The bond bust bodes well for equities

A recent survey of professional pension trustees of UK defined-benefit pension schemes, from Charles Stanley Fiduciary Management, revealed that 82% of trustees believed that they had the knowledge and skills needed to handle the “liability-driven investment” (LDI) crisis. Moreover, 72% of trustees were confident in using LDI as a tool to manage risk and 78% thought their scheme had the right governance in place to handle the LDI crisis. This is laughable.

In response to the greatest investment bubble of all time – which saw the yield on government bonds falling to levels that, according to research by Bank of America, were the lowest for 5,000 years – these trustees saw fit not only to load their funds up to the gunwales with government bonds but also to speculate on further falls in yields using derivatives.

The roots of the LDI crisis
When bond yields started to rise, the losses mounted, leading to the LDI crisis. Pension funds were forced to close out their speculative positions by selling bonds in a falling market to cover their margin calls. This resulted in a market panic, which drove ten-year gilt yields over 4% and sterling towards parity with the dollar.

The crisis has been widely blamed on Liz Truss’s mini-budget. But the fact that bond yields have been rising across the developed world (with ten-year gilt yields recently reaching 4.6% and ten-year US Treasury yields 4.8%), even though inflationary pressures have abated, shows that this is nonsense. The truth is that the trustees were caught in a wholly predictable market crash, which has lost the pension funds, for which they are responsible, hundreds of billions of pounds.

Since March 2000, ten-year US Treasuries have lost 46% of their value (in nominal terms) and 30-year bonds 53%. The bear market may now enjoy a respite, but it is probably not over. As investment strategist Ed Yardeni of Yardeni Research points out, the supply of bonds has increased thanks to the extravagance of governments. Meanwhile, demand has decreased as banks have stopped raising their holdings and central banks are selling (at a loss, inevitably) – in a reversal of quantitative easing. “The question is whether the [rise] in yields is enough to attract enough demand,” he writes. The answer is probably not, despite the urgings of investment advisers – who never saw the crash coming because they were far too busy being bearish about stockmarkets – to load up. Once bitten, twice shy, as the saying goes. 

Bond yields have been below inflation for years and although they are now above it in the US, real yields of 1.5% are not tempting. In the UK, real yields are still negative. What Yardeni calls the “bond vigilantes” still aren’t happy, and they are likely to determine the fiscal policy of governments. That means making borrowing much more expensive, with real yields rising to 3% and governments slamming the brakes on spending. At present, they are only cutting back on planned increases. The age of austerity beckons and with the vigilantes in control, a lot of innocent bystanders will get shot.

Stockmarkets, meanwhile, have been held back by the need for earnings multiples to fall as bond yields rise, but corporate earnings have held up well and are now poised to rise again. In the longer term, the absence of ultra-cheap loans should discourage speculation and low-quality investment but encourage higher returns on capital. This trend, along with the reining in of government spending, should result in higher productivity, higher economic growth and higher corporate profits. Investors have nothing to fear from the bond market crash – they just need to be patient.

The winners of the bond market crash
There have, though, been some real winners from the bond market crash. Defined-benefit pension schemes were so keen to control future liabilities that they offered very generous terms to 64-year-old members, often 25- 30 times their current pension entitlement, to those who wanted to transfer out. Those who did so will have done well, provided they didn’t invest in gilts. The terms offered will now have deteriorated to around 15 times, but opting out may still make sense: who can now trust the actuaries, trustees, managers and regulators of these pension schemes to deliver? It might be better to exit now and weight a self-invested pension fund much more towards equities.

The government appears to have persuaded the big pension funds to invest more in equities, but the agreement hardly inspires confidence. The government wants the investment to be in Britain, preferably in the infrastructure projects it can no longer afford. The pension funds have lost so much money in bonds that they are discredited in investment decision-making and have much less to invest. This does not augur well for the members of their schemes.

There are some pension funds, however, that should be congratulated. The Universities Superannuation Scheme has swung from a £14bn deficit a few years ago to a £7bn – and rising – surplus. This has enabled benefits that were cut to be reinstated and the contributions of employers and members to be reduced. The strong performance is no thanks to the regulator and trustees who were urging the scheme to “de-risk” by switching the portfolio more heavily into overpriced bonds, to cut benefits further and to impose larger increases in contributions. Determined resistance by higher-education establishments, staff and the University and College Union prevented a disastrous change of strategy. Both employers and staff are now reaping the benefits. 

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Paving the way for a more rational investment landscape
This shows the benefit of accountability and proper supervision in the management of pension funds, as in all investments. The more tightly the do-gooders, claiming to protect the interest of scheme members, grasp the funds, the more worried the real owners should be.

The pension-fund trustees who answered the survey are congratulating themselves because rising bond yields have led to their actuarially estimated future liabilities falling even faster than their assets. But the losses in assets are real while the reduction in liabilities is hypothetical. Every billion lost is a billion that should have been invested in infrastructure and other attractive opportunities in the UK or overseas. From that, everyone would have benefited. 

If it takes another 5,000 years for the lows in government bond yields reached in 2020 to be seen again, so much the better. Ultra-low interest and bond yields caused financial chaos. They distorted asset valuations, created false incentives, destroyed the balance sheets of pension funds, encouraged governments into profligacy and syphoned money away from productive investment into speculation. The suddenness of the change has unnerved many who had come to believe that a world of free money was normal. But it paves the way for a much more rational landscape – one that favours risktaking and equities.

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