Investment advisers have been taken by surprise by the recent drop in government bond yields which have inflated schemes’ liabilities and delayed derisking strategies.
The UK 10-year gilt yield currently stands at around 2.7 per cent, a drop from 2.9 per cent at January 6. This so far confounds the consensus prediction of 11 institutional managers in January of a rise to 3.4 per cent by the end of the year.
Last month, US government borrowing costs fell to their lowest levels since June last year, with yields on 10-year government bonds falling to 2.4 per cent and 30-year bonds dropping below 3.3 per cent.
Although yields on 10-year treasuries have since risen above 2.5 per cent, concerns remain for the impact on schemes’ derisking strategies.
John Belgrove, senior partner at consultancy Aon Hewitt, said the US treasury yield falls have been a “major surprise”, serving as a reminder to UK pension funds that liability-driven investment-type strategies are important in delivering a smoother funding journey.
“Longer-duration yields have fallen the most and that affects pension schemes more in a mark-to-market discipline as their liabilities are longer duration,” he said.
“However, this may not be apparent and I estimate that UK pension scheme funding levels have largely tracked sideways this year, where losses due to gilt yield falls have been counterbalanced by gains from rising growth assets.”
Belgrove said a key difference between the US and UK is the derisking appetite among local authority pension funds and the subsequent effect on the longer end of the yield curve.
“[The] UK is erring towards telling the market to get ready for rate rises whereas the US is erring towards telling the market that it will stay low for longer, affecting the front end of the curve,” he said.
Schemes waiting for better prices will not have been hurt by a concurrent hit on growth assets. “Indeed, growth assets have motored ahead, and arguably it is equities and similar risky assets that look vulnerable to a setback,” Belgrove noted.
Strong correlation
UK gilt yields can be highly correlated to those of US treasuries. Rob Skelton, investment consultant at consultancy Xafinity, said: “This is generally bad news for UK pension funds as falling gilt yields lead to higher liabilities,” adding pension schemes that had already hedged their liabilities will have been immune and will have benefited from the equity market rally.
“The fall in gilt yields has arguably been exacerbated by UK pension funds who have locked in the gains,” he added.
The effect could be most apparent at the long end of the inflation-linked gilt market, where there is most demand from pension schemes and a limited supply.
Skelton warned that longer-dated inflation-linked gilts will lock pension schemes into a negative real rate of interest from around 2030 onwards.
“The brave may look to exchange their long-dated inflation-linked gilts for leveraged positions in shorter-dated gilts, where there is arguably better value,” Skelton said.
But Graeme Johnston, partner at consultancy Hymans Robertson, said the falls should not have an impact on schemes’ long-term strategic planning, and at worst schemes will be “temporarily frustrated” at the resultant increased cost of hedging.
Johnston said it was not “significant new territory” for UK pension funds, adding: “Short-term fluctuations in yields since June have been contained within a tight trading range.”
Trustees have also been warned to “look under the hood” of their LDI strategies, as these can target different opportunities at different bond durations.
Le Roy van Zyl, principal in consultancy Mercer’s financial strategy group, said: “A pension scheme’s LDI programme must be seen within the context of the strength of the sponsoring company. That is, where there is sufficient strength it is much more likely to make sense to [instead] wait for more attractive LDI pricing.”
