Surely I can not be the only person concerned at the recent headline in the UK’s Financial Times, ‘UK finds success in a 50-year linker’. The UK government marked a milestone in bond market history in September by raising £1.25bn (e1.8bn) with the sale of the world’s first 50-year inflation-linked bond.
Okay, so pension funds and insurance companies, described in the market as “real money accounts” need long-dated assets, but in the past we always thought of equities as the natural asset class of the long-term investor, now it seems the only long dated asset class that finds favour is “bonds”.
Interestingly, it seems it was UK pension funds, UK insurance companies and other UK investors that bought most of the bonds. Only 10% found its way into continental Europe.
There was apparently £2bn of demand which indicates there will be more to come. However, the really worrying aspect for me was that investors were happy to saddle themselves with a 50-year asset providing a real yield of just over 1.1%, the lowest ever on an inflation linked bond!
For most pension schemes there is no way that the maths will work. Unless a pension scheme has a substantial surplus, a real yield of 1.1% will not fund benefit promises. The more money that gets locked in at that level the harder the rest of a pension scheme’s assets will have to work, unless sponsoring companies start contributing much much more to their schemes.
I have nothing against pension funds buying index linked assets. Indeed, I can read and appreciate very strong arguments for pension funds having a substantial exposure to long-dated index linked bonds, but a real yield of 1.1% – that does worry me.
And all this at a time when inflation is at historically low levels, even when many commodities, especially oil, are at all time highs. I wonder what will happen to inflation if oil prices reverse? I can understand investors being satisfied to receive a return of 16.1% if inflation is running at 15% a year, but to tie yourself down to a return of 3.1% if inflation (as calculated by the government) is 2%, seems very dangerous.
Ascertaining the long-term real rate of return in the UK or the rest of Europe seems to be surprisingly difficult and I have seen many figures bandied about from about 2% a year to nearly 4%. It seems certain that we will not see 4% again for quite a while, but 50 years of 1.1% really does not seem realistic.
I feel confident that if a government tells us it is doing something for our benefit you can be sure it isn’t. So why are so many pension funds apparently willing to commit financial suicide by buying such long-dated stock at such a low yield? It looks like desperation but it could be simply frustration that most other assets do not offer what they need.
Although we are currently seeing bonds trading at yield levels not seen very often (if at all) during the last century, it is probably reasonable to assume that the longer-term sustainable level of government bond yields is much less than that experienced in the 1970s and 1980s. So it is just possible to imagine that the potential loses from an increase in long-term yields may be less than the risk that a pension fund might experience if it sticks to short-term investments if yields were to go lower still.
However, pension funds that have built their actuarial assumptions on the basis that investments will earn a much higher real rate of return are going to have to make some very painful decisions very soon indeed.
Those decisions might include: much higher contributions, lower pensions or delayed retirement or even a combination of all three.
Of course most pension funds will put off decisions like this for as long as possible. Many will look to other avenues of increased return. Most funds cannot afford to increase equity allocations so what appears to be needed is higher-yielding bonds or bond-like investment opportunities, and especially uncorrelated bonds or pure alpha returns.
I have recently seen evidence that emerging market debt has been examined by more funds more seriously than before, and there also appear to be many other opportunities around the world in high-yield debt. Some corporate debt may be seen as unattractive but there may be opportunities in real estate. We now have a few funds choosing to invest in long leases let to big corporations. This is seen as a more secure and higher-yielding alternative to corporate bonds.
I am sure we will see other opportunities. I suspect funds will have to be pretty nimble to grab the best – otherwise they risk being left behind. There are likely to be no prizes for coming second in this game.