Rising interest rates threaten sponsor covenants, say experts

UK inflation rates are currently hovering above the Bank of England’s 2 per cent target level. Inflation based on the consumer price index sits at 3 per cent, while retail price index inflation stands at 4.1 per cent.

Faced with the prospect of rising inflation, the BoE's Monetary Policy Committee voted in November to lift its key interest rate for the first time in more than 10 years, with rates going up to 0.5 per cent from 0.25 per cent.

For a scheme like ours, which is heavily hedged against interest rates, we’ll see relatively limited benefit from a rise in rates

Simon Lee, Marks & Spencers

Rising interest rates are good for scheme liabilities, but represent a risk to the health of employer covenants. Rates might not remain at their raised levels for long, however.

Economists are wary of the onset of a recession over the next few years. This would surely lead to a fall in rates, and a return to quantitative easing.

Interest rate rises could hurt scheme sponsors

Speaking at the Pensions and Lifetime Savings Association’s Investment Conference in Edinburgh this week, Simon Lee, head of the Marks & Spencer Pensions Trust and chief investment officer at Marks & Spencer, was not surprised by gathering momentum for further rises in rates, given recent healthy UK employment indicators.

Unemployment in the UK measured at 4.4 per cent between October and December 2017, down from 4.8 per cent in the previous year.

“For a scheme like ours, which is heavily hedged against interest rates, we’ll see relatively limited benefit from a rise in rates,” he said.

“One benefit we will find, as all schemes will find of course, is that the actual overall value of the scheme liabilities will be smaller, relative to the size of the sponsor,” he added.

A rise in rates will have varying effects on the strength of employer covenants, depending on the industry. A bank, for example, might increase profits through a rise in rates.

However, a retail sponsor would suffer from the effects of suppressed demand from UK consumers, who are typically indebted, according to Lee.

Small rises in inflation could have huge consequences

Schemes and employers can look forward to rates bringing down liabilities. But the spectre of inflation is unlikely to go away.

David Adkins, head of investment strategy at Lloyds Banking Group, emphasised the distinction between near-term outcomes and long-term inflation expectations. US wage inflation statistics and concerns over wage inflation rises have fed into some market models, which have impacted asset prices, he said.

“Probably the more dangerous risk [is] if that feeds into long-term inflation expectations,” he said.

“If [RPI] starts to rise, that really will hit liabilities. A one percentage point increase in inflation expectations would probably equate to something like another 10-20 per cent in liabilities,” he added.

Adkins said that Lloyds is fully hedged on inflation risk, and its credit portfolios have seen a gradual shift to floating rate credit instruments, “which take the duration out of the portfolios, so that we’re not exposed to the sort of unintended consequences of yields rising”.

Was quantitative easing bad for schemes?

The value of the BoE's quantitative easing programme stands currently at £435bn.

Robert Waugh, chief executive and CIO of the Royal Bank of Scotland Pension Fund, challenged the notion that quantitative easing has been wholly bad for schemes.

Waugh argued that in the absence of quantitative easing, disinflation, which he described as “the worst scenario for our pension funds”, could have taken hold.

Such an economic environment might have led to more insolvencies. A thousand companies out of 6,000 have entered the Pension Protection Fund since it was set up.

“How many would that have been if we had had a disinflationary or depression scenario in the UK? Would the PPF have been able to survive that scenario?” he said.