In this week's Informed Comment, BlackRock's John Dewey looks at whether pension funds can afford to hold off hedging their interest rate and inflation risk in the hope of better value.
This has encouraged some pension schemes to postpone hedging liabilities in a belief that yields will rise, thus reducing future hedging costs. Deferring hedging decisions is only beneficial if yields rise faster than the market expects.
Those that wait need to ensure interest rate and inflation risk exposures reflect their specific circumstances and views
Current pricing suggests 10-year real and nominal gilt yields will be significantly higher in five years’ time – 0.68 per cent and 4.42 per cent respectively, compared with -0.04 per cent and 3.21 per cent at December 31 2013 – though the impact on 20-year yields is less significant.
Schemes delaying hedging are therefore assuming current expectations are not a fair representation of the future economic environment and the speed at which yields will rise.
This means investors need to consider the factors driving rates and how these may evolve.
Lessons from history
UK real yields rose for 10 years after the first issuance of index-linked gilts in 1981, and have fallen for most of the following 20 years.
Averaging suggests a real yield in the range of 2-3 per cent a year, but there is no obvious level to which real yields have reverted historically.
Nonetheless, 2-3 per cent is consistent with certain approaches. Economic theory predicts the real interest rate equals the rate of growth in GDP.
Estimating annual long-term growth at around 2 per cent implies a similar level of real rates.
UK real yields are considerably below such levels, in large part due to the macroeconomic factors highlighted below. The way in which these factors develop over time will be crucial to the future path of interest rates.
The fiscal position of developed economies
UK government debt is high, and is predicted to continue growing before it starts to fall. A similar story is true across developed markets.
In the UK, projections suggest a significant reduction in gilt issuance, with the government’s Debt Management Office predicting the financing requirement fall to £76bn in 2018 from £167bn in 2014.
If the government’s borrowing requirements increase, investors may demand higher yields to compensate for worsening fiscal positions. The UK position cannot be viewed in isolation: higher or lower US or European yields are likely to drag UK yields alongside them.
In parallel, there remains considerable demand for gilts to match the long-dated liabilities of maturing UK schemes. This exerts downward pressure on yields.
Expected inflation and monetary policy
The inflation risk premium is a measure of the reduction in yield an investor will accept for achieving inflation protection.
The premium embedded in government debt is arguably higher than before, reflecting greater uncertainty over the path of future inflation. We expect central banks to meet inflation targets over the long term, as developed markets experience a low and stable inflationary environment.
This would reduce the premium and the demand for inflation-protected securities, meaning higher real yields.
Extremely loose monetary policy has affected both nominal and real yields. The timing and manner in which this policy is scaled back is important. If it occurs faster than the market expects, future yields will likely be higher than the currently implied levels.
By contrast, if economic factors such as growth and employment disappoint, monetary policy is likely to be kept looser for longer, depressing yields.
Whether to hedge
We believe UK nominal and real yields will rise faster than expected, though tempered by the factors above. This supports running some interest rate and inflation risk, or unhedged liabilities, as part of a medium-term strategy.
For schemes unwilling to wait, corporate bonds or secure income assets such as long-lease property or infrastructure debt can provide attractive cash flow characteristics with higher yields.
Those that wait need to ensure interest rate and inflation risk exposures reflect their specific circumstances and views, and are considered alongside the other investment risks such as equity, credit and illiquidity risks that their portfolios contain.
John Dewey is a managing director in BlackRock’s client solutions team
