Pension funds in gilt trap
It is a pretty well accepted fact that the UK’s long-dated gilts are very, very expensive. Ian Dickson, UK bond fund manager at Henderson Investors, certainly agrees and adds, “While we agree that the gilt curve is right to be inverted at this stage of the monetary tightening cycle, it is quite clear that current long yields are not at economically sound levels. However, although we think that things already look unsustainable, we think the conditions creating this distortion will remain for a while longer.”
“It’s that two-sided problem,” says Standard Life’s Will Hay, “demand is very strong and supply is diminishing. And as long as both sides don’t change, then gilts will remain expensive, both relative to the rest of the curve and the rest of the world.”
The ‘bad’ news about supply – declining gilt issuance – is, of course due to good news on the government’s finances, which went into surplus in 1997. According to Salomon Smith Barney, there will be a £5bn (e8.1bn) budget surplus over 1999/2000 and, unless the budget moves into substantial deficit soon, then the scope for issuance will continue to decline.
Investors agree that alleviation of the problem is highly unlikely to come from the supply side, and so look to the factors influencing the surge in demand for long-dated gilts. The two main buyers are pension funds and life insurance companies, both having increasing need for gilts as a result of the ageing population. But there are stronger pressures on both groups than changing demographics at work.
For pension funds, much of the ‘blame’ for the rush into gilts, is directed at the minimum funding requirement. The MFR was introduced as part of the Pensions Act in 1995, which was drawn up on the recommendations of the Goode Committee after the Maxwell affair. Few would argue that the primary aim of the MFR, to push pension funds into a more risk-averse position, is undesirable, but in pushing more and more funds into long-dated gilts, the distortion of the yield curve is causing problems, not least for those very funds looking for safe incomes. The government has ordered a review of the MFR; the first report is due in the next few months, and is expected to propose some changes.
Investec Guinness Flight’s Tony Plummer is anxious to dispel the notion that the MFR has to be changed radically. “It is right that pension funds have to pay more attention to their income flows. Over the last 10–15 years there has been a steady drift towards equities and gilt/bond holdings have dropped to about 10%, as equities have performed better. I do not believe the MFR will be changed, but I do think we should be looking to change the pension fund industry’s very strict interpretation of the rules. Non-gilts should be made more allowable to these funds.”
A note of caution is struck by Frank Russell consultant Ken Ayres, who also sits on the National Assciation of Pension Fund’s investment committee. He points out, “We agree that investing in corporate bonds could indeed help, but it won’t be an overnight conversion process. The corporate bond market has to grow and clearly liquidity has to improve. Also the understanding of credit issues has to be developed, which will be a gradual educating process. On the legislative side, the MFR was designed to provide a recognised method of identifying levels of solvency in a pension fund, and is successful in this, but at the cost of too much restriction. I would have to say that the MFR is a contradiction: on the one hand it argues that risk is minimised, but it is explicitly anti-diversification when it recognises only UK equities, bonds and cash and excludes property, venture capital, and overseas financial assets.”
Andrew Kirton, head of UK investment consulting at William M Mercers, says that his firm is already advising clients that they should be looking at alternatives to gilts, such as corporate bonds. “We are sure that a high quality non-government bond market will develop fast, and will provide considerable alternative investments for the funds. “Trustees are already taking a much greater interest in all their bond investing, including investment in corporate bonds. Over the last 12 months we have heard much more discussion about funds using combinations of bond fund managers acknowledging the differing skill sets, such as credit analysis, that each manager might be able to offer.”
The other ‘forced’ buyer of huge volumes of gilts is the life insurance industry. According to Standard Life’s Hay, demand from this quarter has probably passed its peak, although he agrees that there will be an ongoing need for many life companies to continue to buy huge amounts of gilts to match their cashflows, which they are having to pay out to honour obligations to provide annuities with 6% yields. Also, falling mortality rates gradually compound the problem, because the insurance companies have to pay out the annuities for longer.
Although there are no official moves afoot to review or indeed change annuity guidelines, Dickson believes that there is a groundswell of public opinion generated by the well-publicised ‘plight’ of aggrieved annuitants, which may well spur the government into some sort of action. He adds, “It is fair to say that the life companies guaranteed those annuities in the first place, and have thus created much of this mess themselves. However, something needs to be done to take away the fear of having to depend on an inadequate income, and I think this government will sense the political need for action.”
The general view, then, among advisers and the investment management community is that the knot in which the gilt market is tied will remain for the near term. However they agree that there are already avenues which could be followed to alleviate the problems, such as investing in non-government bonds. Corporate bonds are acknowledged as a viable way ahead, but there is agreement that although benchmarks might be broadened to include corporate bonds, there should always be a recognition of the true ‘risk-free’ index, and that investors and their clients need to be aware of their own funds in relation to the sovereign yield.