What if the gilt bubble bursts?

The cost of gilts can surely only go one way - down. And that will hit lifestyle funds hard. Emma Wall investigates

Bond bubble bursting?
Bond bubble bursting?

Thousands of people approaching retirement could see the value of their pension pot plunge – if, or when as some would have it, the “gilt bubble” bursts. The so-called safe asset has been in high demand, as market volatility and economic doom has caused frightened investors to pour money into sovereign debt. As demand increased, so did the prices, and as a result gilt yields have fallen to levels that would have seemed barely believable five years ago, pummelling annuity rates along the way.

We are now in a situation where investors are paying over the odds for this perceived safety – paying a premium that is guaranteed to make a loss at redemption. And not only are gilts expensive, the average 10 year gilt now yields just 1.8 per cent – considerably less than the official measure of inflation.

Gilts may have been the best performing asset of 2011, but experts are predicting this bubble is fit to burst – and if and when it does it will have a negative impact on some people’s pension funds.

Most default funds begin to reduce equity exposure and ramp up gilt holdings as a member approaches retirement, the idea being that this will reduce volatility, preserve cash and make your investments a closer match to the gilts that underly the annuity you are likely to buy.

But the conditions which caused the flee to gilts are improving. The eurozone is looking less threatening, which could reduce the UK’s safe haven status, and volatility is simply becoming the new norm. As other investors grow in confidence and return to equity markets, a fall in demand for gilts would push down the price – bursting the bubble, some fear.

This maybe great news for those looking to pick up cheap sovereign debt in the future, or even thinking of buying an annuity – but is bad news for those approaching retirement in a lifestyle pension fund looking to do income drawdown as they are already locked into a low yield, which they have paid a heavy price for.

The last few years have been a happy set of circumstances for those in lifestyle funds who are in fact planning to go into drawdown, as they have been transferred into an asset class that has risen significantly. While those annuitising have seen rising gilt prices offset some of the pain of falling gilt yields, those looking to do something else have received an unexpected kicker. But if the reverse happens, their retirement dreams could be seriously hit.

Figures by Hargreaves Lansdown predict that when bond yields do eventually rise, lifestyle funds stand to lose investors a lot of money. Hargreaves estimates that if yields on long-dated gilts rise back to levels seen before the Bank of England embarked on quantitative easing, a typical lifestyle fund could lose 30 per cent of its value.

Lifestyling has never been tested in a bond bear market; pension funds started using the technique in the mid-Nineties, and since then the price of bonds has been rising.

Charles Morris of HSBC believes there is no value bonds at the moment unless you believe that perpetual deflation is on the way.

Bond managers are even abandoning their own ship – with fund houses Ignis and M&G warning investor off adding to their bond holdings.

Research by Skandia reveals a third of financial advisers believe UK gilts are in bubble territory and will offer the worst returns over the next year.

Advisers have become sceptical due to the recent incredible performance of gilt funds; something which they believe is a reflection of sentiment rather than fundamentals, and cannot be sustained.

Simon Callow, manager of the multi-asset CF Midas Balanced Growth Fund says that capital losses to redemption are guaranteed in many gilt cases.

“Central bank policy, concentrating on inflation targeting through the use of quantitative easing, adds to the bear case for the asset class. Bonds are now priced to perfection with little room for error. There are even signs of a bubble developing in the asset class, which is being perpetuated by Basel 3 and Solvency 2 regulations, which force banks and pension funds to buy the asset class irrespective of valuation or merits of the asset class,” he warns.

In Sweden this summer, the financial regulator put a 12 month floor on the discount rate used by Swedish pension funds who would normally reference the Swedish benchmark gilt.

But not everyone believes that we are in the midst of a bond bubble.

Demand for gilts remain strong – overseas investors continue to snap up Government debt, as they do not trust their own, and tens of thousands of new investors are entering the gilt market through auto enrolment over the next three years.

Ian Spreadbury, portfolio manager for Fidelity’s Strategic Bond Fund, believes that gilts are certainly expensive, but doesn’t believe they are in a bubble.

Julian Webb, head of DC & workplace savings, Fidelity says: ““We are still in the grip of a global economic crisis. Progress towards reducing gross debt levels has been slow due to a combination of extraordinary central bank monetary policy and the reluctance of governments to impose losses on bondholders. This delays the necessary adjustments to the economy needed to promote self-sustaining growth.

“Falling inflation has allowed the Bank of England to engage in more quantitative easing – but it is only a palliative. It is clear that we are at least several years away from a higher base rate. It is also clear to that capital markets may remain highly volatile with substantial tail risk. This type of environment therefore warrants low gilt yields, even if they have been pushed a little too far by recent ‘safe haven’ flow.”

But whether there is imminent risk of a bond bubble or not – the high price and low return do not make gilts a particularly attractive investment.

Far from return without risk – gilts seem to offer risk without return.

Graham Bentley, head of proposition at Skandia comments: “It is only a matter of time before there is a correction in the gilt market, and investors may be better served by a move from gilts into other asset classes. However, the real growth going forward is likely to come from equities rather than fixed interest stocks.”

The gilt price doesn’t just effect those approaching retirement, it has an impact on retirement income too.

Schroders head of DC Stephen Bowles says that gilts just do not look an attractive investment right now.

“Valuations do not provide a particularly compelling argument for their purchase. It may well be the case that increasing annuity rates may offset some of the impact of future falling gilt prices but there is no guarantee this will be the case. Annuity prices are driven by a raft of often conflicting factors, investors who place all their eggs in the ‘gilt basket’ may well find their purchasing power is not as stable as they had been led to believe,” he says.

In the last few years people buying annuities have been largely protected against falling annuity rates by the corresponding rise in gilt prices – as long as they are in a lifestyle pension fund.

Though there are warnings about a gilt bubble now, over the past decade, the price of gilts has been rising. In contrast, those with large equities exposure have seen the value of their pension fund fall – leaving them with less cash with which to purchase an annuity.

Now facing a potential crash in the gilt market, well-funded lifestyle pension funds will still provide investors with a healthy retirement income, as any fall in bond values immediately prior to retirement should be partly offset by a rise in the income that an annuity would provide.

But what of those people who don’t buy annuities but go into drawdown?

“For those approaching retirement now, lifestyling creates a real risk that they will be switched into gilts when they are expensive and offer a negative real return,” argues Graham Mannion of DCisions.

If you don’t plan to buy an annuity, lifestyling is probably not for you.

Alan Morahan of Punter Southall, the pensions consultancy dismisses the process saying that most drawdown investors buy shares with their pension savings. If their pension fund was previously lifestyled, they will in effect have sold shares to buy bonds, then gone back into shares, which is pretty nonsensical.

Mannion says that some investors may have well from lifestyling because they have bought gilts whose value has increased.

“For those now at the point of retirement who may have already built up a significant exposure to gilts, as with any situation where an investor is sitting on a healthy gain as a result of buying at a fortunate time, it is sensible to consider diversifying their holding and locking in some profit.”

But those people looking to take a lump sum after lifestyling derisking when gilt prices fall now need to diversify.

“The reality is that while much has been made of gilts’ ability to preserve purchasing power for a DC member by reacting inversely to moves in annuity prices, the reality is that often gilts have been used more as a tool to reduce investment risk than a tool to reduce annuity conversion risk,” says Mr Bowles.

“This latter use must now be seriously considered given current gilt valuations and even more so in an environment where cliff edge annuity purchase at a specified point in time is becoming much less of a certainty. Other investment options that provide the opportunity for capturing ‘stable growth’ may well come to the fore over the next few years.”

Willem Sels, UK head of investment strategy, HSBC Private Bank says that there are alternatives to gilts.

“We do not think that there is one perfect alternative to safe haven bonds, but believe that a combination of corporate and emerging market credit, floating-rate notes, inflation-linked bonds, real estate and high dividend equity strategies can offer a more acceptable yield and still provide good portfolio diversification.”

Sels highlights that the traditional role of safe-haven bonds such as gilts and T-bills is to protect against capital loss, provide a steady and predictable income, and offer negative correlation with riskier assets to reduce volatility.

“We believe we can still assume that default risk for the US, UK, and Germany is very low, allowing their bonds to protect against too much capital loss,” he says. “However, at the current low yields, we think safe haven bonds are increasingly unable to fulfil the two other roles.”

So the more risk-on assets may well be the option for those looking to drawdown.

Investors considering drawdown should start by taking stock of their pension portfolio.

“The vast majority of members are not 100 per cent exposed to any one particular market, including UK gilts. Typically DC investors are invested in balanced portfolios including equities, bonds and cash. It is important for DC investors to remain diversified through the lifestyle roll-down,” says Webb.

“For those seeking drawdown, their exposure to any fall in bond prices should limited if they have diversified their investments within their lifestyling programme. As ever DC members need to be checking where their money is invested and if they have any doubts they should go online or call their pension provider.”

Barclays head of corporate & employer solutions, Richard Phelps says that communication between scheme members and providers is key if losses are to be avoided.

“For individuals who are considering income drawdown, it is important that these individuals take advice throughout the whole life cycle of drawdown. This means taking specialist advice years in advance of drawdown commencing – for example participating in a lifestyling strategy that invests in bonds and cash in the years before retirement may not be appropriate, as drawdown by its nature will require some equity investment in the drawdown phase. Once in drawdown, it is imperative that regular reviews are undertaken.

“It will therefore become increasingly important for custodians of pension schemes, whether they be the trustee, employer, provider or adviser to provide clear communications on the options available at an early stage. They will also need to provide access to quality advisers and ensure that the range of investments offered in pension schemes cater all of the options that will be available at retirement.”