Gilts still retain some lustre
Even when offering negative real returns, Gilts are generating interest as a risk-free asset
- Gilts are expensive compared with other global bond markets.
- Probably the only international investors looking to buy UK Gilts are central banks.
- For pension funds, matching pension liabilities is seen as a risk management issue rather than an investment decision, so the pricing of debt has become irrelevant.
- The UK parliament is discussing the possibility of launching a national sovereign wealth fund financed by issuing Gilts sold to UK pension funds.
Why would anyone want to buy Gilts? The UK sovereign debt market is expensive compared with other global markets. Long-term inflation expectations are relatively high at 3.45% a year over 30 years on the Retail Prices Index (RPI) and 70bp lower on the Consumer Prices Index (CPI). Long-dated yields are relatively low (see chart).
In contrast, in the US, 30-year inflation expectations are 2% with 30-year US Treasuries yielding 2.9% a year at the end of April, compared with 1.7% for Gilts. “So you end up with a market where real yields are deeply negative and much lower than in other markets. That does not look an attractive investment proposition for a global investor,” says Myles Bradshaw, head of global aggregate fixed income at Amundi.
The situation reaches the realms of parody when it comes to index-linked Gilts. There, investors interested in lending to the British government for 50 years will be rewarded by having 1.88% a year taken away from them in real terms and 1.9% if they were to lend for 20 years. That situation is not an anomaly. Real yields have been negative for some time. It is necessary to go back to 2011 to find a time when they were consistently positive.
What drives the UK sovereign debt markets into an Alice in Wonderland world of negative real yields is not international investors but domestic ones driven by financial repression. That situation, if anything, is getting worse – in the latter part of 2016, pension funds saw a recovery of solvency ratios driven by equity markets. The effect was to encourage more pension funds to try and lock in their solvency levels through purchasing liability-matching Gilts, says Daniela Russell, assistant portfolio manager at Legal & General Investment Management (LGIM).
Probably the only international investors looking to buy UK Gilts are central banks. Sterling is still a minor reserve currency, providing a rationale for non-profit-maximising entities to want to hold some. But on any long-term perspective, it seems difficult to see, on a global basis, how the UK can be expensive and have higher inflation without there being consequences for investor appetite for the UK bond market. The long end is still part of a global market place so it can only be decoupled from the rest of the globe to a limited extent.
Moreover, the uncertainties over Brexit add a further disincentive for overseas purchases of Gilts. Over time, the market will want a higher risk premium for the uncertainty, depending on the type of Brexit deal negotiated. A harder Brexit deal would imply a greater risk premium, and this may be expressed through the currency market. A stronger parliamentary majority for Theresa May’s Conservatives following the 8 June national election would give the UK government more flexibility to negotiate a Brexit deal that provides economic stability. That should be positive for sterling, according to Bradshaw, reducing inflationary pressures, meaning a better economic outlook, and that the UK would behave more like other global markets.
In the base-case scenario, over next five years, BlackRock estimates that there is likely to be four times the demand relative to the amount of supply of index-linked Gilts. That figure is arrived at by assuming that pension funds would broadly aim to get to a fully funded on a technical provisions basis over 10 years. The assumption is then that they miss their target and only get to 90% funded by de-risking their portfolios. Finally, it makes certain assumptions of shape of issuance, and estimates of debt issuance overall with about 25% as index-linked. The result compares with a current imbalance of twice as much demand as supply. While the UK’s Debt Management Office (DMO) has been receptive to issuing where demand is most strong, the UK’s index-linked market share already looks high relative to other global debt markets, says LGIM’s Russell. As BlackRock argues, the supply demand imbalance could get even worse in coming years.
BlackRock finds that the demand for take-up of long-dated yields is showing no signs of slowing down. “You might expect as real yields have fallen, people would want to buy less of it,” says Vivek Paul, director, client solutions at BlackRock. “If anything, we have seen the opposite. We traded more Gilts and index-linked than ever before in 2016, when yields hit all-time lows.”
LGIM is advising its liability-driven investment (LDI) clients that it expects yields to structurally remain low and, as a result, those looking to hedge liabilities should take any advantage of fluctuations in yields upwards to buy Gilts, rather than waiting for yields to go up 50 or 100bps, says Russell.
For pension funds, matching pension liabilities is seen as a risk management issue rather than an investment decision, so the pricing of debt has become irrelevant. Pension funds are therefore unable to invest in long-term risky assets, whether in the UK or overseas, despite having long-term liabilities. As things stand, UK defined benefit (DB) pension funds are scrambling for an asset with sufficient supply to satisfy demand for risk-free assets while also scrambling to reduce the investment risk within their asset portfolios.
There may be a way out of this impasse. Pension funds are unable to take on investment risk because they need to match liabilities with Gilts. But the ultimate risk taker in a country is the state itself.
The UK House of Commons, the lower house of parliament, has debated the idea of setting up a UK sovereign wealth fund last December. The existence of ultra-low and negative Gilt yields does give the UK government one attractive option. That is, to issue a large amount of long-dated Gilts and invest the proceeds in assets such as equities which have higher dividend yields than bond yields. Moreover, the dividends from emerging market equities would, in effect, be produced by younger populations outside of the UK.
It would, of course, in effect be a state-owned hedge fund, but with the proviso that the state can always print more sterling if the assets become less than the liabilities. A UK sovereign wealth fund financed by issuing Gilts sold to UK pension funds would, in effect, be acting as an intermediary guaranteeing pension funds the ability to meet their liabilities while generating much higher cashflows from elsewhere.
Insurance companies are already developing attractive businesses buying out pension schemes and competitively pricing them through their own ability to take on additional investment risks. The sovereign wealth fund would be indirectly performing the same function.
At some stage, it could, of course, do this directly if it could issue debt with a sovereign guarantee. Imagine then, a sovereign wealth fund that hoovers up pension fund assets and reinvests them in risky long-term but higher-return investments while giving pension funds a guaranteed liability-driven set of investments.
Whatever the merits of ideas such as a UK sovereign wealth fund, the UK’s pension industry needs some radical rethinking in its approach to buying assets that guarantee losses.