Bond bubble

Owners of prime developed world government debt should prepare for danger ahead. This is the message coming from two of the biggest managers of pension fund money.

Fund manager feeling

The most adamant view comes from Legal & General Investment Management. Tim Drayson, economist at the firm, says: “There is nothing safe about this asset class – we are in bubble territory. There is scope for yield to rise in a meaningful way.”

The concern of Drayson and many investors is that with yields dipping into negative real returns, any sudden shift of sentiment in the market could lead to a large sell-off, as investors look to hitch a ride to a better risk return. It could just be that investors, particularly in the Far East, stop buying into the asset class.

10-YEAR GILT YIELD (Monthly average) Source: Royal London Asset Management/Thomson Reuters Datastream

Drayson adds that if gilt yields rise as a result, then the return on corporate bonds will be “pretty lousy” in comparison, and these too could lose value.

This is also, broadly, the house view of BlackRock.

In its outlook report, published at the start of the year, it said: “Prices of safe-haven government bonds and similar assets could plunge when yields start to rise. Low yield = high price risk.”

It identifies the needle that will prick the bubble as a growing number of investors who are prepared to sacrifice safety and liquidity to gain a little extra yield.

The report states: “Quality businesses and dividend stocks would likely underperform leveraged companies as the flow out of income could result in a temporary ‘dash for trash’. Casualties would be ‘safe’ assets such as government bonds of the US, UK, Germany and other eurozone core countries. It takes just a miniscule rise in yield to trigger sizable bond price losses.”

However, there are others at BlackRock who take a more measured view of this prognosis.

At an investment briefing just before Christmas, Richard Urwin, head of investments within BlackRock’s fiduciary mandate investment team, said his clients were unwilling to re-risk aggressively – the implication being that BlackRock’s clients have the volume to move the market.

At the same briefing, Rick Rieder, chief investment officer of fundamental fixed income at BlackRock, said a limited supply of safe fixed income (gilts and corporate bonds) would ensure stability in prices.

He said: “The world is still in deleveraging mode. This means less debt is issued, so there is a limited supply of fixed income. It is not a bond bubble, there is still not enough supply around.”

Interestingly, for investors seeking a return better than the dismal offerings from gilts, both LGIM and BlackRock backed a focus on high-dividend equities and emerging market debt.

Graham Wardle

Managing director at BesTrustees

_{Mixed Blessings}

As QE programmes come to an end there is concern that a ‘bond bubble’ has been generated which could burst, resulting in a significant fall in pension scheme asset values, perhaps 30 per cent or more. What would be the consequence of such a major correction?

Well, most defined benefit schemes are in deficit and so, although there would be a big fall in asset values, there would be an even bigger fall in liability values (which are driven by gilt yields). As a result the deficits would fall, so trustees should not be too unhappy.

The situation in defined contribution schemes is different, though. For members in the accumulation phase there would be little impact, assuming no change in equity markets, but a big fall in bond asset values could have a major impact on the annuity an individual could purchase – because although annuity rates should, in theory, improve, the annuity market is far from perfect and rates are also impacted by actions in Brussels and continuing improvements in longevity. So for a DC member nearing retirement, the bubble bursting could be a disaster.

Neil Morgan

Senior trustee at Capita

_{Establish a 'risk budget'}

Predicting the direction of interest rates within any kind of precise timeframe is one of the most difficult aspects of investing.

We would therefore argue that establishing goals against a pre-established ‘risk budget’, regardless of the current level of interest rates, should be the focus for trustees and plan sponsors.

The decision on how much to hedge interest rate risk is actually much easier than it is to make a forecast of interest rates. And moreover, it is likely to have a bigger impact on a scheme’s funding level than any other decision.

Ideally trustees will have in place a framework that has determined how much interest rate risk they currently feel comfortable with, having taken into account their objectives and risk tolerance based on, for example, the covenant of the sponsoring employer. So how much are you willing to let the funding position decline in bad times in the pursuit of higher returns?

Part of this should be a clear pension risk management framework with a journey plan that takes you from where you currently are to where you want to be – which is to be fully funded over a reasonable period of time.

Part of this plan will be ‘triggers’, so that if interest rates do increase from here, resulting in an improvement in the scheme’s funding level, the trustee governance framework is sufficiently robust and nimble to be able to move quickly to derisk, locking in these gains.

Helen Roberts

Investment policy adviser at the National Association of Pension Funds

_{Modest growth makes a bond bust unlikely}

The mood has changed, with hopes that growth is picking up, especially in the US. But we need to be cautious as this might be a case of new-year exuberance.

The bond bubble is unlikely to burst anytime soon as pension funds still need to hold significant amounts in bonds to match their liabilities and to meet regulatory requirements. Clearly in this context, higher yields can be good news for pension funds as they tend to increase discount rates used to calculate liabilities, improving the overall funding position. But growth is expected to be modest in the UK this year, with little prospect for interest rates to get much higher any time soon.

Additionally, the Bank of England has commented that the anticipated unwinding of quantitative easing, which has artificially brought down yields, is unlikely to happen until after interest rates have started to rise.

The toxic combination of higher growth, higher interest rates and the unwinding of QE could lead to the bursting of the bond bubble but it is unlikely to be now.

Nick Sykes

European director for consulting at Mercer

_{Demand sustains bonds}

Will the bubble burst? Not necessarily. The potential demand for gilts from pension schemes wanting to derisk remains enormous. As other assets such as equities rise, funding levels will improve and trustees will be encouraged to take risk off the table by buying more gilts.

If the current economic regime of massive bank deleveraging, fiscal austerity and monetary stimulus persists, with anaemic growth, this could sustain gilt yields at depressed levels for some time to come.

Chetan Ghosh

Cio at Centrica Combined Common Investment Fund

_{Clamour for matching assets}

Yields probably do need to rise somewhat, but in the UK I doubt we will see the bursting of a bubble due to the pent-up demand that BlackRock cites.

UK pension schemes want to hold more matching assets, but at a better yield than we see today (although not that much higher). Therefore, in the UK, yields could rise a little, but pension scheme demand is likely to limit the extent.