Investment Grade Credit: Any life in long-dated bonds
With £100,000 (€155,255) to purchase an annuity, a 55-year-old prospective retiree could expect an annual income of between £4,500 and £4,900 without any inflation increases, and with nothing for his dependants should he die the day after purchase. Yet, if he invested the £100,000 in an equity income fund, he might expect dividends of £5,500, and he might also expect those dividends to rise over the long term. Moreover, his dependants would gain the full value of the fund whenever he died, even if it was 50 years later. Of course, equity capital values can be volatile – but dividends and dividend growth has tended to be much more stable.
It is not surprising that after the UK government announced a relaxation of the requirements to purchase annuities out of DC pension savings in its spring 2014 Budget, Legal & General’s Q1 2014 sales of annuities fell by 40%. The firm forecasts that the annuity market will shrink to a quarter of its pre-Budget size by the end of 2015.
Annuity business represents around 10% of profits for the main UK providers such as Legal & General, Aviva and Prudential. They expect a 50%-plus fall in their annuity business, but it is not likely to be a fatal blow. Furthermore, the bulk-purchase annuity business coming out of corporate pension schemes is likely to continue unchanged, or even to grow.
“There are really three groups of retail investors with different likely behaviours,” says Neil Williamson, head of EMEA credit research at Aberdeen Asset Management. “Those with small pension pots of less than £20,000 may just take the money out and spend it. Those with very large pension pots have always been able to take a drawdown option, so they would be unaffected by the legislation. Those with medium-sized pots ranging from £100,000 to £400,000 are the ones who will have the biggest impact on the marketplace as they look for alternatives to annuities.”
What are the implications of all this for the sterling debt markets, where so much demand comes from the country’s life insurers?
“We have been seeing some ultra-long paper coming out in the sterling market – things like Mexico’s 100-year bond, for example,” says Robert Gall, head of market strategy in the financial solutions group at Insight Investment. “The advantage of issuing that sort of stuff is going to be much less obvious following the decisions in the Budget, simply because there may not be the same annuity-market demand that was the real backbone to that trade.”
UK Government figures show that only 10% of the flow of around £11bn a year from new annuity business goes into Gilts; market participants estimate that about two-thirds buys corporate credit. With the majority of the annuity flows predominantly invested in long-dated fixed-income securities, logic says that there should be a negative impact – but, as yet, there has been no real sign of a sell-off.
Estimating what the eventual impact will be is not straightforward, as Ben Bennett, credit strategist at Legal & General Investment Management explains. “In terms of immediate reaction, a few businesses have announced a decrease in the amount of annuities but there is still a lot of uncertainty over the overall impact,” he says. “If we assume £3-4bn does not go into long-dated fixed-income assets, then the question is, does that impact the markets? Clearly it would affect the markets if the supply of long-dated debt remained unchanged. But from an issuer perspective, there are global corporate bond opportunities. Large corporates have a choice of issuance both in terms of currency and also in terms of maturity. From a sterling perspective, maybe they will start to issue shorter-dated bonds; or perhaps they will diversify into dollars or euros a little bit more.”
A little less long-dated issuance at the margin and a little more shorter-dated has, in fact, made itself felt in market pricing, with a slight steepening of the sterling yield curve.
“You can hardly see it in the charts,” notes Bennett. “The credit curve did steepen by five basis points on a generic level between 10 and 30 years, but that is not a huge amount. I would not expect it to steepen a lot because the amounts involved are not huge, and the issuers have got a larger opportunity set beyond long-dated sterling. If the curve did steepen dramatically, then no one would issue 30-year corporate bonds.”
Longer term, what might determine the future of the annuity business and also the size of long-dated primary issuance in the bond markets is likely to be the relationship between long-dated bond yields and dividend yields. Fund managers now have an enormous opportunity to develop income funds that are focused on producing stable dividend streams that can be used as alternatives to annuities for UK retirees.
Under current conditions, this is relatively easy as virtually any equity income fund would offer yields comparable to or higher than an inflation-linked annuity. Once fund managers have structured products that can be shown to have a stable and increasing income stream with a high degree of probability, it is an easy argument to make that they represent better value than an annuity – as long as the investor pursues a buy-and-hold strategy designed to produce income, and can ignore the volatility of capital values in the same way that an annuitant ignores bond market prices. Long-dated bond yields could rise to levels significantly above dividend yields, in which case annuities might make a comeback – although even in this scenario, if the reason is high inflation, equity dividends may still look like a better bet to the retiree.