UK - Pensions funds are being warned to tread carefully at present when deciding whether to hedge their liabilities against UK gilts, as the huge level of government borrowing is likely to mean yields will need to rise in the short-term to attract borrowers.

A study into liability-driven investments by asset manager F&C argues gilt yields appear to be a "free lunch" for investors at present compared with swap rates, yet pension trustees may find schemes with a deficit will not see the benefit of investing in gilts.

More specifically, while the role of government bonds varies from scheme to scheme, those funds with higher deficits might actually be better off hedging just a fraction of their liabilities to gilts while yields are high over the coming months and instead allocating to swaps or other assets and drive return-generating strategies which might help pull back that deficit.

Alex Soulsby, derivatives fund manager at F&C, claimed many schemes with deficits do not have the assets to be able to reduce their liability risks by investing in gilts unless they can sell out of all other asset classes, so swaps could appear to be the better investment option, despite investor reservations.

"Using swaps means that only a fraction of assets are dedicated to hedging and therefore the portfolio can continue to invest in return generating assets and in so doing seek to reduce the deficit over time," said Soulsby.

"The big question is whether pension schemes should be investing in government bonds that have yields fractions of a percent above swap rates, rather than equities or corporate bonds that are at their lowest prices for a generation. The main argument to support why they should is that swaps are expensive but we disagree," he continued.
"With so little capital available and so much government issuance to come, we think it is more likely that the relationship between gilts and swaps continues to look like it does today than how it looked over the last 10 years. Gilts are useful but swaps provide the means for most schemes to hedge liability risks while accessing the return assets they need," suggested Soulsby.

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