UK - Pension funds need to broaden the range of financial instruments for hedging activities in order to tackle the problem of negative index-linked gilt yields, according to one investment consultancy.

At Thursday’s market close, all UK government bonds with inflation protection ended with a negative yield-to-maturity (YTM).  Among three-month lag index-linked gilts, YTMs ranged from -1.125% to -0.026%, while the lowest yielding eight-month lag bond ended with a YTM of just -2.161%.

Robert Gardner, co-CEO of investment consultancy Redington, said: “Pension schemes should maximise their toolset in order to capture opportunities.”

“We have seen an increasing use of gilts, swaps, repo, total return swaps and swaptions for liability hedging purposes, as well as the separation of inflation and interest rate hedging,” he said.

Some pension schemes were using liability driven investment (LDI) asset managers who had the authority to make active relative value decisions, Gardner said. “There is also the option to source long-dated inflation-linked assets, such as water companies or social housing,” he added.

Pension funds should now prepare for nominal and real yields remaining low for several years, he said.

A number of factors had conspired to turn index-linked gilt yields negative, he said. Long-end nominal yields were under pressure from the worsening economic outlook, and expectations that the Bank of England would buy up more gilts under its asset purchase programme was adding to the load.

Gardener also cited the flight-to-quality status of UK gilts in the current euro crisis and the fact that inflation indicators CPI and RPI were above 5% as circumstances weighing on yields.

Added to this was the high level of demand from index-linked money managers at Debt Management Office auctions, he said.

“This move in real yields will force the mark-to-market value of liabilities higher and higher for all schemes and lower funding ratios for those with a low hedge ratio,” he said. Around 80% of schemes had a hedge ratio of less than 50% and were likely to see their funding level fall significantly, he said.

Where yields would now go in real terms was uncertain, Gardner said, adding that they could be pushed even lower if the factors behind the downturn continued forcing nominal yields down.

“Fund managers who are short duration versus their benchmark may get stopped out and forced to buy-back the bonds,” he said. “It is worth looking to separate nominal and inflation hedging and build up this protection tactically.”