Within the past ten days the real yield on the 50-year Index Linked gilt-edged security has fallen to just 0.9%. There are significant economic, equity and corporate implications for investors to consider.
Although the ultra-low nature of long-dated bond yields has elicited much media comment of late, the truth is that bond yields have been on a declining trend for quite a while. The reason that they are attracting such interest at the current time is that the end-March deadline for the submission of pension fund valuations to the Pension Protection Fund (PPF) is fast approaching.
The PPF was set up to pay compensation to members of eligible defined benefit pension schemes on those occasions when an employer becomes insolvent and has insufficient assets within the scheme to meet its liabilities. This asset-liability mis-match has sent funds into a feeding frenzy, scrabbling for those index-linked gilt-edged with durations which broadly match the long-dated nature of their pension liabilities.
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It is worth noting that the proportion of gilt-edged stock which is index linked has been rising, but despite that, only about 30% of these index linked stock have maturities in excess of fifteen years! (7.5% of the entire stock of gilt-edged).
Clearly this supply / demand mis-match has created a major distortion in the market (Note that there has been no such supply / demand mis-match in either the US or the eurozone, resulting in a UK yield curve significantly out of kilter with other developed bond markets.
The technical detail is based upon the fact that funds are required to calculate the present value of their liabilities by discounting at a rate which is derived from the yield on long-dated index linked. However, ultra-low yields have boosted the implied present value of future pension liabilities. As the recent crawl over BOC's accounts in the wake of the approach from Linde, the German chemical business, has shown, BOC has around a £445m pension liability, equivalent to about £1 per share. Most company pension funds are in fact far from achieving full asset-liability matching and the lower that real redemption yields fall, the greater the net liabilities become.
A vicious circle is being created. As lower bond yields increase net fund liabilities, those funds become ever more desperate to move toward liability matching by increasing their purchases of long-dated bonds. But this demand raises prices and depresses yields still further, thus increasing net liabilities.
With the likely arrival of a pensions regulator, which might impose severe penalties on those companies which fail to address their pension fund deficits in a period of, say, ten years, companies may almost certainly find themselves being forced to make payments into pension funds from internal resources at the expense of investing in the business.
The Chancellor should take note of this, given his continuing lament regarding the relative lack of investment in the future being made by UK-based corporations, although privately he may not care too much as lower yields are helpful in reducing government finance costs too!
The one marginally positive impact of ultra low long-dated gilt-edged yields on the corporate sector is that borrowing costs for those companies have fallen. Admittedly, most firms do not borrow at ultra-long index-linked rates.
There is also likely to be an adverse impact on those current retirees having to take out annuities at very low yields.
What Could Be Done To Break The Vortex?
The regulator could act to cool pension funds' aggressive appetite for long-dated bonds by announcing a stay in the time period required to achieve liability matching. There are a sufficient number of technical ambiguities in the law to encourage most companies to adopt an ultra-cautious interpretation of the rules. An overhaul of the rule book could go some way towards reducing the extent of the supply / demand imbalance.
This may seem like an obvious point, but the government could take advantage of ultra-low yields by issuing more ultra-long dated index-linked stock at prevailing low yields. It has even been suggested that the authorities might go further and redeem short-dated bonds, lengthening the duration profile of the gilt-edged market.
The Debt Management Office has already acknowledged that it may be about to announce an alteration to its financing plans (possibly to coincide with the release of the Debt and Reserves Management Report) in mid-March.
Despite the practical fact that comparing equities with bonds means comparing real with nominal yields, intuitively one knows that there should be a link since equity markets should value shares on the basis of the discounted present value of expected future dividend payments (dividend discount model).
Whilst the relationship might be expected to be stronger with conventional gilt-edged than with index linked, in general the supply / demand mis-match has resulted in lower long-dated conventional yields too, thus a lower discount rate, thus higher equity values.
A lower discount rate should have resulted in good outperformance by UK equities over their US and eurozone counterparts. But the fact that this didn't happen indicates that investors may already (intuitively) be offsetting a lower discount rate against the negative effect of increased pension liabilities on company balance sheets. Other factors could be at work here too, including the perception that funds might have to continue to sell equities to fund bond purchases.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley
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