Gilt investment reaches post-crisis peak at £22bn

Concerns about the effect of inflation on scheme liabilities and a desire to mitigate the impact of market volatility have driven schemes into buying increased volumes of government fixed income.

The ONS data show investments in UK government bonds are now at their highest levels since 2005.

Schemes invested £11.8bn in index-linked gilts last year, compared with £9bn in 2011, while investments in fixed-interest gilts topped £10bn in both 2011 and 2012 up from £7bn in 2010.

The trend is set to continue, according to Paul Kitson, pensions partner at PwC. “There is a lot of pent-up demand to move out of return-seeking assets into matching assets such as gilts,” he said.

Schemes are hungry for government bonds as long-duration, low-risk assets “because there aren’t many other places they can go for that”, he added.

This has been demonstrated by a dramatic rise in investment in gilts at the end of 2012 and the beginning of this year, with inflows of £5.5bn in Q4 2012 and £6bn in Q1 2013, up from just over £2bn in the third quarter of last year.

Bond allocations have been rising due to regulatory pressure and a desire on the part of sponsors to stabilise the impact of funding levels on company balance sheets and escape volatility in equity markets.

“We have seen a shift in fixed-interest gilts to index-linked gilts over the past couple of years,” said Phil Edwards, principal at consultancy Mercer.

Schemes have been concerned that developed market monetary policy and quantitative easing could lead to higher inflation in future, and are increasingly wanting to hedge this indicator, said Edwards, adding: “There have been opportunities to switch from fixed-interest gilts to index-linked gilts at fairly attractive levels over the past couple of years.”

How Xerox matches liabilities

Xerox’s defined benefit scheme has over the past year started to build towards a target hedge of 45 per cent of its liabilities.

In its strategy document released in June 2012, the scheme shared its plans to increase its hedging at a rate of 1 per cent of liabilities a month until December 2012, adding a hedge of 0.75 per cent of liabilities each quarter this year.

In March last year, the scheme had hedged 24 per cent of its liabilities, according to its 2012 annual report. “The purpose of this approach is to hedge a proportion of the risks associated with the scheme’s exposure to movements in interest rates and inflation,” the report stated.

The scheme’s liability-driven investment manager can use gilts and index-linked gilts, corporate bonds, corporate inflation-linked bonds and asset-backed securities to deliver this strategy.

A variety of derivatives including interest rate swaps, inflation swaps, asset swaps and futures can also be used. These decisions can be accelerated if more attractive market conditions arise.

Edwards said that over the past few years lots of schemes have put in place trigger mechanisms to allow them to capture changes in gilt yields.

“We would expect to see, if and when yields rise, a reasonable amount of activity on the part of pension schemes that have already put these triggers in place,” he added.

A survey released last month by KPMG on the LDI market found an 11 per cent growth in hedging liabilities.

“Thirty-five per cent of mandates now have triggers in place to extend LDI when yields rise,” said Barry Jones, head of LDI at the consultancy.

As gilt yields stayed close to historically low levels, it has become apparent to schemes that some triggers would never be hit. “Many schemes have had to revisit triggers to revise them down,” he added.

The biggest theme of the year was the growing sophistication techniques used in mandates, Jones said. “In an environment where cash is king, derivative-based strategies appear to be a popular way of controlling key risks while freeing up assets that can earn a premium invested elsewhere,” he said. 

Derivatives are unfunded, giving schemes leveraged exposure, meaning they can cover off the risks and free up capital to invest elsewhere. “It becomes an efficient way to cover off inflation and interest rate risks,” he said.

The £2bn scheme closed to new entrants at the end of 2008. In March 2011, its funding level was 88 per cent, however since then “there has been a significant worsening of the scheme’s funding position as liabilities have increased faster than assets have grown”, according to the 2012 report. The scheme did not want to add further comment.  

Mercer’s most recent asset allocation survey found an increase in index-linked gilt exposure. “We saw UK schemes shift their government fixed income split from about 45per cent/55 per cent [fixed/index linked] in 2012, to 35 per cent/65 per cent in 2013,” Kitson said.