The best way to short gilts

How much lower can government bond yields go? Not much, warn some heavyweight fund managers. Yields could soon rise sharply, sending prices tumbling. Are they right and what should you do?

Earlier this month, the yield on ten-year British government gilts fell to 1.9%, the lowest level for 300 years. Why? Investors have sought the relative safety of Western government bond markets since the financial crisis began. In theory, any government can go bust, but Western ones hold some ace cards.

Governments like Britain's may be hugely indebted due to overspending, but their liabilities are backed by tax revenue. That makes their IOUs safer than bonds issued by most firms. So international pension funds and other big investors, desperate to protect their capital, have been buying their IOUs.

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Factor two is quantitative easing (QE). The British government can print the money it needs to meet its liabilities. It can also buy back its own debt. To force money out of gilts and into the wider economy, the government has done just that pushing up prices and squeezing yields. So what's changed?

Nothing, according to Andrew Clare, professor of asset management at Cass Business School, writing in the FT. He reckons pent up demand from UK pension funds will keep gilt prices high (and yields low) even if foreign buyers pull out. Throw in another dose of QE after disappointing fourth-quarter 2011 GDP figures and gilt prices will ride high in 2012.

But others aren't so sure. British gilt yields are well below the rate of inflation. Investors will happily dump them and seek higher returns if the economy revives. What will the trigger be?

"The catalyst for pulling the trigger on selling gilts is the improvement in the US economy," says Peter Geikie-Cobb of the Thames River Sterling Global Bond Fund on Professionalpensions.com. He thinks improved US jobs data suggest the worst is over.

If the gloom over eurozone jobless data lifts with a successful round of sovereign debt refinancing, he sees yields on "safe" bonds "exploding" upwards. Yields on Italian bonds (which are seen as risky) have already nearly halved from a high of 7% as prices tumbled after the European Central Bank fired its "big bazooka".

Gambling on a spike in gilt yields is risky the Bank of England may hold them down for some time. And shorting government bonds directly is nigh on impossible. The best bet is a short gilt exchange-traded fund, such as db x-trackers UK Gilts Short Daily ETF (XUGS). Just don't bet the farm on it.