What gilts are telling us about the UK economy

published 15 December 2006

Yields on UK government bonds are at extraordinary lows. This has caught pension funds up in a vicious circle and could have serious consequences for the UK economy.

Gilts: is there a problem?

Yes. Yields on some UK government bonds are extraordinarily low. The yield on 10-year index-linked gilts is now just under 1.25%, while that of 50-year gilts recently hit just 0.38%, well below the UK long-term average of about 3%. It is also well under the yield on similar US government bonds, which yield roughly 1.5%. The bond market is pricing interest rates at only 0.25% above inflation in 20 years' time, says UBS Global Asset Management. Usually, that would indicate the global economy is heading for a deep depression.

Gilts: what do the markets fear?

Not necessarily. There are plenty of theories as to why global bond yields are so low. Some blame Western central banks for keeping interest rates far too low for too long, creating a tide of cheap money that has been used to drive up the prices of all sorts of assets around the world from commodities to houses, to bonds (higher bond prices mean lower yields). Others point the finger at Asian governments for buying up bonds in an effort to keep their exchange rates artificially low and boost their exports. And others blame a so-called savings glut' by Asian consumers that is being reinvested in the bond markets. But none of these factors explains the extremes in the gilts market, which is being distorted by pension funds.

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Gilts: how have pension funds distorted the market?

By buying up gilts in an effort to close their pension deficits. This is largely being driven by changes in UK pension regulation. On 1 January this year the pensions regulator acquired sweeping powers to force firms to close their pension deficits within ten years, including the right to stop companies paying dividends or engaging in share buybacks. Meanwhile, the Pension Protection Fund will levy a charge on company pension funds the hardest hit will be the schemes with the biggest deficits. That's a big incentive to close the deficit.

Gilts: why buy bonds?

Because they offer pension schemes the best protection against the risk of being unable to meet their obligations to their members. The only way to be sure a fund will have sufficient cash to pay out pensions to its members in 20 to 30 years is to invest in assets that will yield sufficient funds to match those liabilities. That means bonds and particularly index-linked bonds since most UK pension funds are linked to inflation. The snag is that the move is proving increasingly self-defeating.

Gilts: why is the pension deficit growing?

Because the lower bond yields fall, the higher the deficits grow. Under UK accounting rules, a pension fund's liabilities are measured using the yield on an AA-rated corporate bond. In other words, what value of corporate bonds would you need to own today to pay out all the pensions promised by the scheme? This can create a vicious circle. The more companies buy bonds, the lower their yields fall, the higher their deficits rise, which means the more bonds they need to buy. Mercer, the pension consultants, calculated that the pension deficit of UK companies had risen from zero in 2001 to £100bn last year, despite the contribution of rising stockmarkets.

Gilts: what is the effect on the UK economy?

In the short term, it's good news particularly if you're looking to borrow money. But over time, the impact of all this money pouring into the gilts market via company pension schemes could hurt the UK economy. After all, the money pouring into the gilts market is money that companies could be investing on their own behalf. And companies are likely to put the money to far more productive use than Gordon Brown ever could. This huge transfer of capital from the corporate sector to the UK government via bonds will reduce Britain's capital stock and undermine our competitiveness. That means there will be less money to pay the pensions of future generations.

Gilts: what can be done?

One option is for the pensions regulator to relax the rules so that funds are no longer forced to buy into a bond-market bubble. The snag is that the regulator is not interested in protecting companies, but only in ensuring the Government is not landed with the bill for failed pension schemes. A second solution is for the Government to issue far more index-linked bonds. That would have the double advantage of boosting gilt yields, and thereby cutting pension scheme deficits and providing the Government with cheaper financing. The pension industry is begging the Government to issue more long-dated index-linked bonds, but it's unlikely the Government will issue enough to satisfy demand. That suggests UK gilt yields could stay low for a long time yet.

Gilts: what will become of Britain's pension funds?

Already 70% of UK final salary schemes are closed to new members. Last year, Rentokil Initial became the first FTSE 100 company to close its scheme. Others are sure to follow. Meanwhile, many companies are keen to offload their pension fund liabilities once and for all by taking out protection from an insurance company to cover them against further shortfalls. At the moment, this cover is expensive and only two companies Prudential and Legal & General offer it. But new players are about to enter the market offering cheaper products. As the deficits mount, companies may soon come to regard it as a price worth paying to rid themselves of a problem that will not go away.

By Simon Nixon, executive editor of Breakingviews.com