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Bitter medicine

Central banks are preparing to flood the market with paper on the one hand while ‘printing money’ to hoover it up on the other. Martin Steward asks what it means for bond yields, pension fund solvency and asset allocation over the coming months

It began at the Federal Reserve. The US central bank is committed to buying up to $2trn (€1.47trn) of bonds and mortgage-backed securities (MBS) this year. The Bank of England (BoE) followed in March, announcing plans to buy £75bn (€846bn) of 5-25 year gilts. On 7 May it revealed plans to spend a further £50bn. For the European Central Bank (ECB) things are trickier because euro government paper is issued by 16 sovereign countries, but it has reached a (sketchy) agreement to buy €60bn of covered bonds.

Quantitative easing: like most medicine, it’s supposed to be good for us but can taste bitter. 

“If it works, the economy improves, equities recover, credit spreads come back,” says Robert Hayes, managing director in BlackRock’s strategic advice and solutions team. “Interest rates would eventually be able to edge back up and yields rise, helping on the liabilities side as well. But short term, mark-to-market buyout liabilities and solvency will look worse.”

Why? Because a price-insensitive buyer would be expected to push bond yields down. This could be a good thing for Dutch schemes using the swap rate for discounting. The negative swap spread in place since last autumn has been ugly for their liabilities, so a clearer announcement from the ECB could make their asset-liability match look healthier. But UK pension funds use yields on corporate bonds for FRS17 or IAS19 discounting of liabilities, and government bond yields for ALM studies and Section 179 valuations (which determine Pension Protection Fund levies). Here, low bond allocations mean that falling liability-discount rates won’t cancel out rising prices. This is compounded by the refusal of the Debt Management Office (DMO) to meet their huge demand with meaningful supply at the long end of the curve.

Regulatory restrictions on pension funds selling government bonds, or reluctance to disrupt liability-hedging portfolios or dump the one asset unscathed by the recent crash, could compound QE’s downward pressure on yields.

“That could come as a shock to companies that have focused on accounting liabilities, where corporate yields have made for quite a rosy picture lately,” says James Morgan of KPMG’s investment advisory division.

Indeed - and even those yields have started to come in now, across most sectors, not just the defensives which have been the focus of the BoE’s advances. Some, like Toby Nangle, director in Barings’ multi-asset team, have called for a suspension of FRS17 so that companies which might take advantage of QE’s low-rates are not held back by pension-deficit millstones around their necks.

“The Dutch are big on solvency, but they’ve agreed to give solvency tests a rest for this year,” observes Stuart Thomson, chief economist at Ignis Asset Management. “Solvency tests for the insurance industry were relaxed in 2002. The PPF in the UK hasn’t really done this, and I think there’s a case for doing so this year.”
So much for the theory. In the real world, after a strong initial response, yields soon clawed their way back up, and during the week the extra £50bn of BoE purchases was announced 10-year yields rose by 20bps.

“I think [BoE governor] Mervyn King is in danger of damaging QE’s efficacy because he’s a lukewarm advocate,” says Tim Hodgson of Watson Wyatt. “You need to leave no doubt in the market’s mind that you’re not going to stop until you’ve driven those yields down.”

The £220bn worth of gilts that will flood the market over the coming months must have something to do with their stubborn buoyancy. The picture is mixed: on 28 and 30 April, the UK DMO got £4bn of gilts away, two-times over-subscribed; but March saw a 40-year issue go 7% under-subscribed; and in the US, on 7 May, the Treasury was bid up to a 4.288% yield on $14bn of 30-year bonds - much higher than expected.

“Virtually all governments will have to lose their AAA credit rating,” says Thomson. “In a balance-sheet recession you have to socialise credit risk to enable your corporate sector to recover.”

In a way, the ideal outcome for pension funds would be governments intercepting the corporate sector’s bullet: risk assets would recover as long-dated government yields crept up to soothe sceptical investors, eating into liabilities. It would also extend the period of grace afforded by the negative swap spread to re-coupon liability-hedging swaps.

“We never expected yields to come down rapidly,” says Hewitt’s Tapan Datta. “But pension funds and sponsors rely on the broader health of the economy, so QE is relevant.”

From that perspective, rising long-dated yields no longer look like good news. They may reflect higher inflation expectations (as currency markets suggest), a killer for pension funds with index-linked liabilities - with the UK’s 5% cap on inflation-linking applied cumulatively for deferred pensioners, recent years of below-5% inflation will mean quite a wait before that cap kicks in.

It is not surprising that markets would instinctively feel that printing money should be inflationary: “It’s hard for me to see how QE could not lead to inflation,” as Amarendra Swarup of Pensions Corporation puts it. “Because you do not reverse the policy until you see signs of recovery, the danger is always that you wait too long.”

Pension funds are responding. The latest Pension Pulse Poll from Pyramis Global Advisors, surveying 233 US corporate and public pension plans in mid-April, found many more planning a shift to “fixed income and immunisation” over the coming decade. “The large European institutional investors we work with are considering more use of index-linked bonds, commodities and real assets, and LDI,” adds Patrick McNelis in global distribution and client service.

In the UK, unfortunately, inflation swaps remain quite illiquid and inflation-linked bonds look expensive. Pent-up demand is not being met by the DMO - probably because it, too, expects higher inflation. (Following its closure to new accruals in 2007, the BoE’s pension fund began a very significant move out of equities - into inflation-linked gilts. “What did they know that we didn’t?” muses KPMG’s Morgan).

But inflation-phobia can be overdone. “That £125bn is there to fill in a hole, not build a mound as well,” says Sam Hill, a fixed income manager with Threadneedle Investments. The Fed’s $2trn won’t fill the US’s $11trn hole. It recently estimated that strict application of the Taylor Rule would put the Fed funds rate at -5%. And for all the talk of governments welcoming inflation, any study of 1936-38 reveals that mistakes can easily be made in the opposite direction. More recent history from Japan also challenges the notion that QE necessarily means net inflation. Ultimately, deflation is the scarier prospect. It grinds economies into the dust, and because index-linked pension payments cannot go negative it expands the real value of scheme liabilities, too.

The BoE’s decision to add £50bn of QE before spending the initial £75bn looks like a response to deflation concerns: it predicts inflation at 0.5% by year-end and possibly still trundling below target at 1.2% in two years’ time. But it also warns of “significant risks in each direction”.

“We think concerns about high inflation are premature,” says BlackRock’s Hayes. “But the lesson from the last two years is that tail events have a habit of happening. What if we end up like Japan with grinding deflation? What if things take off and we get runaway inflation? You need to consider both scenarios.”

Which is fine in theory: take a relative-value, range-trading approach to inflation-linked bonds; and hold onto your nominal long bonds, ready to jump ship when inflation picks up again. Unfortunately, that requires better timing of the regime change by pension funds than we expect from our central banks. Implementing something strategic to negotiate between the Scylla of inflation and Charybdis of deflation is almost as tricky.

Corporate bonds should certainly be part of the solution. For a start, pension funds are already hugely exposed to spread-narrowing from an IAS19/FRS17 perspective. In the deflationary scenario, coupons still help with liability-matching (subject to increasing defaults), while in the inflationary scenario, shorter duration and credit spreads will help. 

“With 1970s-style stagflation, corporate bonds would not look so attractive,” says Nangle. “But with high single-digit inflation the illiquidity and credit risk premiums are still sufficient to compensate investors over the next few years.”

For some formal optionality, convertible bonds are an obvious choice, along with synthetic convertibles - equity-derivative overlays on portfolios of nominal and inflation-linked government bonds.  

“It’s very difficult to develop a strategic asset allocation when the two possible scenarios are so different,” says Robert Gardner of Redington Partners. “But, given the negative swap spread, instead of putting swaps over their growth assets many pension schemes have sold their equities, bought gilts and replaced their equity exposure with futures. They have a large portfolio of gilts matching liabilities, and a framework in place to get equity risk back on the table very quickly if we get a sudden recovery.”
 

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