From the blog: Why don’t you want to invest in bonds yet? Is it because interest rates are going to rise, which will make them cheaper to invest in later?
But the market already prices expectations of interest rate movements, so on this basis it is unlikely that the price of bonds will fall by as much as you expect.
The real question we should be asking is: “Are interest rates likely to increase by more than already priced into the market?”
We must be wary of falling foul of complacency in this low interest rate environment.
When it comes to investments, it is commonplace to worry about rare but potentially hard-hitting events. An analogy is the fast driver who thinks he is an expert in tailgating the car in front until, on his 20th trip, he is unable to stop in time and crashes.
Running parallel to this scenario is the pension scheme manager who is not hedging her bets because she believes it is a given that rates will rise: she may suddenly become very exposed if her expectations are not met. She may have to disinvest at a point when her assets have unexpectedly fallen in value.
Slow death
Another analogy is the persistent, overoptimistic mindset, such as the smoker who thinks the next cigarette won’t kill him, so he continues to smoke. He stops years later, but the damage is already done.
In the case of the pension scheme, there may be persistent optimism about the direction for interest rates and a return to more ‘normal’ levels of return.
However, the year-on-year accumulation of lower than expected returns becomes the root cause of a slow but sure atrophy in the health of the scheme.
In order to avoid making the wrong investment choices and persistently underfunding the scheme, the underlying lesson is to take nothing for granted.
I always answer two fundamental questions: First, have I correctly assessed the risk of my investment strategy with modelling and scenario analysis?
Second, have I assessed how prudent my estimates are for the rates of return for funding the scheme in the light of what my modelling and scenario tests have told me?
With these questions appropriately dealt with, we are far more likely to be able to be prepared for events like Mark Carney’s swerve on rates, or worse.
Alan Swallow is senior actuary at consultancy Cartwright Group
