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Pension funds warned over wait for UK Gilt real-yield improvement

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The real yield on index-linked UK Gilts is expected to remain low longer than pension funds anticipate, warns AXA Investment Managers (AXA IM), meaning schemes waiting to hedge liabilities may be disadvantaged.

In a white paper, the asset manager said it was not uncommon to hear index-linked Gilts described as expensive, particularly as real-yields remain negative.

However, despite this, strong demand remains, evidenced by over-subscriptions for two long-dated, index-linked Gilt auctions in recent months.

This could result in an even stronger burst in demand from waiting schemes should real-yields creep above 0% through a longer-term recovery – but this would, in turn, cause demand pressure to push yields back to the status quo, AXA IM said.

Jonathan Crowther, head of LDI, said because index-linked Gilts remained expensive and yielded negatively, some schemes were intentionally, or unintentionally, exposed to interest rate and inflation movements.

“When real yields do start rising, we only expect demand for long-dated, index-linked Gilts to rise,” he said.

“This wall of demand will continue to put pressure on the long-end, thereby anchoring yields.”

AXA IM predicted long-dated real-yields to remain below 0.5% for the foreseeable future and, given the supply and demand dynamics, unlikely to rise above 0% in 2015.

“Negative real-yields may persist for much longer than many pension schemes might think,” Crowther said.

Consequently, those waiting for real-yields to rise significantly before hedging their risk may have to wait rather a long time.”

The warning comes after the yield on a 2068 index-linked Gilt hit -0.6% last month and was followed by the announcement from the UK government that borrowing would fall over the long term.

In chancellor George Osborne’s Autumn Statement, an update to Parliament, it was said Gilt issuance as a whole would decrease after 2015, only hampering rising yields from a supply perspective.

Earlier this month, research backed by Pension Insurance Corporation revealed UK defined benefit (DB) funds would experience a £500bn shortfall in index-linked Gilt issuance, leaving many schemes unhedged.

It said funding levels would improve by the end of the decade due to rosy economic circumstances.

However, it said pension funds would be unable to hedge away interest rate and inflation risks due to the shortfall in supply.

The UK National Association of Pension Funds (NAPF) previously criticised and lobbied the government over its index-linked Gilt issuance, suggesting DB funds remained overly exposed to risks.

However, in an interview with IPE, Robert Stheeman, chief executive of the Debt Management Office, said index-linked Gilts remained a core strategy for the government, but it could not issue these exclusively.

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