The bear market in bonds isn’t all bad news

Is the rise in bond yields and corresponding fall in bond prices bad news or good news? It depends on your perspective.

In the last year, yields on ten-year gilts (UK government debt), having been barely positive a year earlier, rose from 0.5% to a mid-June peak above 2.5%, though they have since slipped back to 2.1%. 

Yields on 30-year gilts have risen from below 1% to over 2.5%, resulting in a capital loss to holders of these bonds of 20%.

Given that these yields remain below those of the comparable US Treasuries (US government debt) against the historic norm, it is likely that they will continue to rise and that the multi-century lows of a year or two ago were an anomaly.

Who owns all our debt?

This is clearly bad news for holders of gilts – but most private individuals sold out long ago. Maybe some pension funds still held some, though they would be wise to keep that quiet. Insurance companies, who are heavily restricted by “solvency” rules, are significant holders of gilts, but mostly short-dated ones with little capital risk and a modest yield premium over cash deposits.

The big holders, according to the Financial Times,  are now “overseas” – central banks on behalf of their governments as part of the deployment of their foreign exchange reserves – and the Bank of England, which has bought back £875bn of gilts, 45% of the total in issue. 

This means that the UK government’s debt-to-GDP ratio, nearly 95% gross, is only 52% net, though that would rise if the Bank of England has to sell some or all of those gilts to rein in excess liquidity. Excess liquidity would be the result of a surge in bank lending, which has been severely curtailed since the financial crisis, but that looks unlikely to happen.

The other big loser from higher gilt yields is the government and, through them, the taxpayer who, as existing gilts mature and are refinanced, will have to pay a higher interest rate. Debt service costs, excluding those on gilts owned by the Bank of England, currently sit at £40bn per year. That’s 1.7% of national income and 4.3% of public spending. This is  set to rise inexorably.

On the other hand, ultra-low borrowing costs have encouraged the government to spend vast amounts of money on vanity projects such as HS2, though, fortunately, they have not (yet?) reached the lunacy of France’s nationalisation of EDF. Curtailment of government extravagance would be positive for taxpayers and the economy, even if higher rates do raise the hurdle for private sector infrastructure spending.

Why rising gilt yields can be good news for pensioners

Other potential winners are risk-averse pensioners, who are at last seeing annuity rates rise. This means that the lump sum in their pension pots will buy a higher lifetime income – one which is completely safe from market and economic volatility – than it did a year ago. Annuity rates are estimated to have risen 23% since their low in early 2021.

The other big winners are members and providers of fully-funded defined benefit pension schemes. Notable among these is the Universities Superannuation Scheme, a £90bn fund covering over 400,000 people employed in higher education.

In recent years, the fund has been reporting mounting deficits, reaching £14.1bn at the March 2020 valuation. Assets were calculated by the actuaries to be only 83% of commitments, though calculations depend on a number of assumptions. These include: longevity, future contributions, investment returns, future pension entitlements and – crucially – discount rates. The latter, the rate at which future liabilities are discounted to the current day, are based on gilt yields.

A sensible critic might argue that there are so many uncertain assumptions as to make the conclusions highly unreliable, but the trustees have to follow the “professional” advice of the actuaries and the employers have to implement the recommendations, subject to any push-back they can exert. 

The employees had seen a remorseless squeeze on their entitlements and a sustained rise in their contributions. The rise in employer contributions was passed onto them (higher education institutions having little spare room in their finances) in lower pay increases. The result was understandable fury and a series of trade union-supported walk-outs across the country.

A further squeeze on benefits was implemented at the start of April. But soon after, the Universities Superannuation Scheme announced that its 31 March valuation had shown that the deficit had fallen to just £1.6bn, making the scheme 98% funded. Moreover, this was primarily due to an increase in assets rather than to a higher discount rate, the result of higher gilt yields, reducing liabilities.

Since gilt yields rose further in the second quarter and, notwithstanding the recent decline, are likely to rise further still, the position of the Universities Superannuation Scheme and other defined benefit schemes is likely to continue to improve. 

In the short term, weak markets, notably equities, will have reduced assets but these losses will be soon recovered as markets resume their long-term relentless move upwards.

Staff should now be able to look forward to a reinstatement of benefits and/or lower contributions while the financial squeeze on higher education will diminish. 

The losers are the actuaries, whose reputation is tarnished, and the trustees who loyally followed them. As one bemused finance director said, “the pensions system is supposed to reduce the volatility of everyone’s exposure to the vagaries of markets but it’s done precisely the opposite.”

There is one final loser from the rise in bond yields – advocates of “modern monetary theory” (MMT) who claim that government spending should not be constrained by rising debt as central banks can just create money to finance it. This theory attracted a following among progressive economists and politicians but has now been buried.

The recent rally in bond markets helps limit the scale of necessary interest rate rises and underpins equity markets. But in the longer term, a return to yields which are moderately higher than much lower inflation would mark a return to sanity.