OPERATION DOUBLE-TWIST

There’s a lot to be learnt by looking back through history. However, it is not just your own history that is important, and particularly not when trying to use the past to peer into the future.
 
As gilt yields hit fresher and fresher lows, they bring many questions to pension fund trustees trying to improve their funding level or looking to hedge their liabilities:
 
    – Is it safe to buy gilts?
    – Is it time to sell gilts?
    – What are gilts and why are they destroying our funding level??
 
Here we will consider the following: Could gilt yields move even lower? If so, what would it mean for pension funds?
 
Positive means negative for ‘safe havens’
 
Zero is only a bound until it’s not” – Philip Rose, Head of ALM at Redington
 
A few European countries have recently broken through the ‘Zero Bound’ of interest rates, with investors willing to pay these governments to borrow money from them. Those nations with control of their own money, or a strong economy, are now facing an unknown unknown – negative nominal interest rates. This is great news for government borrowing costs but far from great news for pension funds that will see their liabilities soar.
 
The UK has thus far avoided negative rates. However, with 2 year gilts returning just 0.09% (before inflation) it may not be long before we join the group of nations with sub-zero rates. Negative nominal rates could happen even without further rate cuts or quantitative easing as investors are free to decide how little interest they are willing to receive from, or indeed how much they are willing to pay for, gilts.
 
If quantitative easing fails to ignite growth – as appears the case given Q1 and Q2 GDP figures – will the Bank of England focus their policies on short-term interest rates again? UK base rate is currently at 0.5%, leaving 50bp of cuts to play with. There is even the possibility the base rate could turn negative, to the detriment of pension fund liabilities exposed to interest rate risk.
 
For example, Danish banks have started to charge customers for leaving cash on deposit and the ECB are said to be considering it:
 
    “ECB policymakers Benoit Coeure and Klaas Knot have since hinted further cuts may follow if necessary, suggesting they are not afraid to experiment and go sub-zero with the deposit rate” – Reuters “ECB mulls Danish-style deposit charge as lending prod”
 
Negative interest rates aim to have a dual impact:
 
    – Force banks to start lending rather than be penalised for holding cash at central banks
(We ask: Is this likely while banks are still deleveraging/derisking and economy is in recession?)

    – Encourage idle cash sitting in private accounts to be used for investment
(We ask: Corporations may look to invest but what about individuals? More from BBC “Super-rich hiding at least $21tn”)
 

Negative nominal yields may well occur in the UK, but could they also happen elsewhere? If so, it will not just be UK pension fund trustees searching for higher returns away from government bonds – the global investment community will be doing the same thing. Many investors are already switching into corporate bonds, emerging markets, infrastructure debt/equity but there are only so many of those assets to be bought before even they turn into low yielding assets.
 
A worsening Eurozone crisis, deflationary pressures from UK recession, regulatory changes forcing institutional investors to hold least-risky assets and the opportunity for banks to charge customers keeping cash on deposit all mean that UK government could soon find itself being paid by investors to issue debt. It would also mean that gilt prices may not have reached their peak just yet…..
 
What would it mean for pension funds?
 
Should we enter a period of negative nominal interest rates on gilts, funding ratios will deteriorate dramatically as liabilities balloon and assets fail to rise in value quickly enough. Endgame strategies, such as buy-ins and buy-outs, will become more expensive. This would also put pressure on sponsors to prop up their pension funds via increased contributions, something that might be tough to achieve during a recession.
 
Nobody ever said being a trustee was going to be easy, but I guess nobody ever said it was  going to be this hard!

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]