By Virginia Furness and Tommy Wilkes
LONDON (Reuters) - Volatile sterling and the prospect of a damaging no-deal Brexit aren't hurting demand for British government bonds among foreign money managers, who are betting the debt will outperform if the UK does end up making a disorderly exit from the European Union.
The rally in British debt since June has halved yields on 10-year bonds, and while the moves are part of a global scramble into top-rated assets, a chunk of the new buyers are overseas managers positioning for no-deal Brexit, according to investors and bankers with experience of managing sovereign bond sales.
Added to this are relatively attractive yields -- 10-year gilts, as UK bonds are known, yield 0.55%
"You see (overseas) investors thinking very simply: where can I still get yield from," said David Zahn, head of European fixed income at Franklin Templeton.
Zahn, who has been buying gilts as a Brexit hedge, said this was a more attractive trade than betting against the pound -- the currency could rebound after Britain leaves the EU.
"If you see a no-deal Brexit, gilts will outperform," he said.
Bank of England data show foreign investors poured 7.3 billion pounds ($8.87 billion) into gilts in June, the latest month for which figures are available. Cumulative inflows since April were 19 billion pounds. Last year from April to June, non-residents added 1.5 billion pounds to gilts.
Monthly numbers can be volatile and are not seasonally adjusted. Redemptions of maturing bonds in one month can also distort data.
BoE figures show that cumulative inflows from overseas on a 12-month rolling window topped 32.8 billion pounds in June -- the highest since September 2017.
(Graphic: Foreign investment into British government bonds link: https://fingfx.thomsonreuters.com/gfx/mkt/12/5157/5114/gilts.png)
Two London-based bankers told Reuters European buyers had been looking to diversify away from negative-yield home markets. In countries such as Sweden and Germany, all government bonds yield less than 0%, meaning investors are guaranteed to lose money if they hold bonds to maturity.
The bankers said the gilt trade had gained in popularity after Boris Johnson became prime minister in July and pledged to leave the EU by Oct. 31 with or without a transition agreement.
Asian investors have also been buying, one of the sources said, speaking on condition of anonymity.
Despite increased foreign buying, the source cautioned that domestic investors, who dominate the market, accounted for most of the new purchases.
For foreign managers, the cost of hedging sterling risk can wipe out any yield advantage from gilts. For euro-based buyers, for example, 10-year gilt yields approach the -0.6% that German Bunds pay, after hedging.
What investors are banking on is that after a disorderly Brexit, gilts will rally sharply.
"We are long gilts at the moment, we have set up a spread: long gilts versus short Bunds," said Marc Kersten, portfolio manager at German asset manager Union Investment.
A Brexit shock would sharply lower gilt yields because Britain's economy would be hit far worse hit than the euro zone's, he predicted. He said he would load up on more gilts if they sell off.
Currently, money markets expect only a quarter-point interest rate cut in Britain by March 2020, compared with more immediate easing priced in for the United States and euro zone.
BoE policymakers have said rates could move either way after a no-deal Brexit. But most investors expect the central bank to slash rates quickly and even resume money-printing stimulus to stave off recession. Data show UK output already contracted in the second quarter.
"The outlook for the UK economy is challenged and the prospect of any interest rate hikes seems vanishingly small," said Sunil Krishnan, head of multi-asset funds at Aviva Investors. "The flow of funds does show euro zone investors remain significant participants in the gilt markets."
A spokesman for the UK Debt Management Office said the increase in overseas gilt holdings may reflect investors rebalancing portfolios after recent sterling weakness.
Not everyone thinks buying gilts makes sense.
Alex McKnight, a portfolio manager at GAM Investments, recommends betting on a plunge in sterling instead of buying gilts, because the currency was likely to fall further with a no-deal Brexit than it would rise with a positive outcome.
Fund managers also warn that higher government spending to offset damaging Brexit consequences would actually boost yields, especially on longer-dated bonds. Some fear that any move toward higher spending in Germany and elsewhere would end the global bond rally.
"The moves in gilts could be quite violent downward, but then quickly reversed," said Colin Harte, multi-asset strategist at BNP Paribas Asset Management.
(Editing and additional reporting by Sujata Rao; editing by Larry King)