Schemes urged to lock in gains as market improves

The gradual increases in yields since April last year have worked in tandem with improving equity markets to help scheme funding levels, and trigger some movement from growth to matching assets to lock in market gains.

A Pensions Expert survey of 11 leading UK institutional asset manager forecasts produced a 3.37 per cent yield for a 10-year UK gilt at the end of 2014, up from the current yield of 2.94 per cent (see graph).

The greatest yield of 3.5 per cent was predicted by seven managers, while Insight Investment was the only manager to foresee a fall in yields, to 2.85 per cent.

Schemes that have held out on derisking in the hope of better value will be vindicated by the trend, but consultants have warned them not to rely on future increases.

“The time has come to be locking a bit more of the risk up, and one wouldn’t want to overdo waiting for those higher rates,” said Tapan Datta, head of global asset allocation at consultancy Aon Hewitt.

But he added: “There is probably a bit more juice [left] in terms of holding out.”

For most schemes these rises, accompanied by a rise in equity valuations, would be helpful for solvency, said Alan Wilde, head of fixed income and currency at Baring Asset Management.

“Having said that, a lot of UK schemes have moved to immunise their liabilities and [already] hold a substantial amount of bonds compared with previous years,” he added.

The big unanswered question is how equity markets will respond to developed countries’ central banks removing support for their economies.

Losses could more than offset any funding gains from rising gilt yields. “Periods of indigestion or worse are possible,” said Datta.

A rise in gilt yields could impact negatively on liability-driven investment programmes, said Mark Nicoll, partner at consultancy LCP.

“If technical provisions come down and a scheme is fully matched on an LDI basis, the portfolio will fall by a similar amount,” he said.

In hindsight, schemes may have been better off not implementing these strategies, said Nicoll, but he added most schemes are not 100 per cent hedged.

“So even if they lose value in their LDI portfolio, the benefit they will get to their technical provisions reducing will be more,” he added. “So they will still make some gain.”

However, Philip Rose, chief investment officer for strategy and risk at consultancy Redington, said schemes’ main exposure is to 30-year real yields.

In depth: manager views

Neil Williams, chief economist at Hermes Fund Managers:  “Forward curves globally are probably right to infer only a modest (30-40bp) gradual rise in bond yields over 2014. At this stage, this suggests 2014 closing with a roughly 3.3 per cent 10-year gilt yield, versus 2.95 per cent currently.”

Richard Stevens, fixed income fund manager at Threadneedle: "While we do not anticipate the Bank of England to hike the base rate this year, this may well start to happen in 2015. In the meantime, monetary policy could move into the spotlight again, despite Governor Carney’s commitment to clear communication.

"The economy continues to normalise and the key unemployment rate is likely to soon approach the 7 per cent target level. A reduction to 6.5 per cent could therefore be on the cards, or a broad data-dependent policy approach based on variables such as average earnings, spare capacity and credit demands."

Ben Bennett, head of credit strategy at LGIM: ""In terms of the implication for pension funds, it depends on how equity markets react to higher rates. Modest yield rises should allow equities to remain strong, providing a great opportunity for pension funds to derisk and lock in more attractive interest rates.

"But the risk scenario of significantly higher rates may lead to weak equities and undermine the solvency of schemes that are heavily invested in stocks."

John McNeill, fixed income manager at Kames Capital: "Our general view is that there will be small upwards pressure on 10-year yields but that the move will not be very significant as the bank rate will remain unchanged. 

"However, my personal view is that 10-year yields could end the year slightly lower than now. This is on the view that if the economy continues to grow strongly the front-end will have to price an eventual rate rise and the curve between two years and 10 years will flatten."

Mike Dueker, chief economist at Russell Investments, on a predicted increase in the US 10-year yield: “A key part of the outlook for the yield is that we are expecting payroll employment gains of 230,000 jobs per month in 2014, which is significantly higher than the Blue Chip consensus projection of 194,000."

Philippe Waechter, chief economist at Natixis Asset Management: "The 10-year yield is higher due to the recovery in the UK and the contagion from US rates to the UK. At the moment long term interest rates in the US are well priced. The implicit five-year rate in five years is already close to its average. As a result we do not expect a strong upside on long term interest rates in the US.

"In the US stronger growth prospects will lead to higher anticipation on interest rates next year and the year after. This will imply higher interest rates on the two to five-year segment. This will have a contagion impact on UK interest rates. Some pressures of the same kind will be seen in the UK."