Bonds – Going down slowly?

Markets are predicting interest rates will rise more quickly than the timetable set by the Bank of England’s Mark Carney.
Emma Wall investigates what that would mean for DC funds

On August 7, new Bank of England governor Mark Carney set out a plan designed to offer savers, borrowers and the City some stability regarding interest rates. Base Rate had been at a record low level of just 0.5 per cent since March 2009, but the market was divided as to how long we could expect this to continue.

In his August inflation report, Carney announced that the Bank would be implementing ‘forward guidance’ – a plan already much anticipated by the markets as it had been successfully executed in Carney’s former incarnation as head of Canada’s central bank.

Going forward, he announced, Base Rate would be linked to the health of the economy – in particular using the measures of unemployment and inflation.

The bottom line? The Bank would not be raising rates until unemployment has fallen to 7 per cent or less – it is currently 7.7 per cent – unless inflation rises above 2.5 per cent. Meaning it will be another three years until interest rates start to rise.

Cue a mass sigh of relief for mortgage holders, debtors and house builders and a rush to just about any income paying asset on the markets.

But fast forward to just one month later and the cracks have started to show in Carney’s strategy.

Reports suggest that recent positive economic data has buoyed investors to the extent that a rate rise may come as early as Q4 2014 – two years earlier than planned.

If this is the case, it would negate the entire premise for forward guidance – to offer stability to investors. So how can long-term investment schemes such as pensions map out asset allocation, or pension holders make important decisions about their annuity when the future of rates, and income, looks uncertain?

Berenburg chief UK economist Rob Wood says that while it is unlikely the Bank of England would enforce more quantitative easing, he expects unemployment to reach the 7 per cent threshold by Q3 2015, so the Bank will need to raise rates sooner than the late 2016 date Carney has signalled.

The latest minutes from the Monetary Policy Committee (MPC) emphasised that the 7 per cent threshold for re-considering rate rises was not a trigger, so rates need not automatically rise when the threshold is reached. But the market seems to have backed an alternative outcome.

The market is indeed implying that there will be a rise in interest rates before 2015,” says Hymans Roberstson partner Mark Jaffray.

This is primarily because the market now expects economic growth and inflation to rise faster than has been signposted by the Bank in its ‘forward guidance’. What does that mean for pension funds? Pension funds hold long term assets such as equities, long dated bonds, so the impact on pension funds of an earlier rise in short term interest rates, really depends on the reaction of equity markets and bond markets to any increase in rates.”

Some fluctuations may already be expected by the market, and therefore priced in. But if equity markets fall – as they may well do if cash offers a more attractive return – and bond yields rise, then pension fund assets will fall in value.

But it’s not all bad – Jaffray adds that a loss in value may actually benefit scheme members.

That fall in value may be wholly compensated by a fall in the value of the liabilities – for pension schemes with deficits this may actually be positive for funding levels and deficits,” he said.

Jupiter institutional director Charlie Crole says rate rise could be a positive thing for defined benefit (DB) schemes, certainly more so than DC schemes.

This is because many DC scheme members, except those in the later stages of their working life, tend not have allocation in gilts, whereas DB schemes have broader asset allocation throughout their membership.

A rise in interest rates implies rising inflation and gilt yields. This would be positive for those pension funds, at least in the shorter term, looking both to “de-risk” and to reduce deficits,” Crole explains.

But this would be true only to the extent that they had retained other assets like equities which had not fallen in value in tandem with gilts. Matching gilts could be purchased at cheaper prices using these other assets. This might not necessarily be true, however, for the underlying membership of these pension funds, the real purchasing power of whose pensions would be reduced by higher inflation.”

He said that as always when discussing de-risking schemes need to bear in mind exactly whose “risk” is being reduced.

One area where DC scheme members will benefit from rates rising is when they come to buy an annuity – as their retirement income would be greater.

Aon Hewitt defined contribution consultant John Foster says that a rise in bank rates won’t necessarily immediately affect the long term rates that are mainly used in setting annuity rates, so pension savers should consider delaying the purchase.

Any step change in interest rates insofar as they do affect bond and gilt capital values may take time to be reflected in annuity rates so some members may need to delay drawing benefits if they feel that either capital values will bounce back or annuity rates might improve if they wait,” he said.

It is hard to predict the impact on bonds and gilts but it will vary between different types and durations so it will also depend on what the fund is holding and how this flows through to annuity pricing.”

Although DC scheme members may not have allocation to gilts and fixed income for the majority of their investment, when they approach retirement many default schemes implement lifestyling, selling scheme members out of high risk assets such as equities and focussing on capital preservation.

Since Bank Rate was lowered, people buying annuities have been largely protected against falling annuity rates by the corresponding rise in gilt prices – as long as they were in a lifestyle pension fund.

If gilt yields jump, and prices fall, lifestyle pension funds will still provide investors with a healthy retirement income, 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 it is no longer compulsory to buy an annuity. Investors with pension pots of £100,000 or more can use drawdown to withdraw an income from their pension fund.

Although this method gives investors more control over when and how they spend their pension pot it also means that there is no balance to the fall in value members may experience having been switching into gilts during the final phase of their investment- meaning they are already locked into a low yield, which they probably paid quite a price for.

Barclays Corporate & Employer Solutions investment consultant Lydia Fearn says that most default options assume that members will use 75 per cent of their pension pot on an annuity and take 25 per cent cash benefit on retirement.

This is not only the case for lifestyling strategies, but target date strategies also move towards the same end point,” she says. “Therefore there is the very real prospect of members seeing a fall in the value of their assets as they approach retirement, although any rise in rates should ultimately flow through to an improvement in annuity rates.”

This creates problems in that many DC members do not understand fully why they are invested in those assets and the reason that a fall in value does not necessarily mean an equivalent rise in the level of annuity they will be able to purchase.

A recent paper from the Office of Fair Trading said that this lack of understanding was a problem through the DC market – ruling that DC schemes were over-complicated and difficult to understand.

Fearn says: “A lot more work needs to be done to communicate to those members and allow them a chance to make an active decision on how their assets should be invested. 

It is another potential bad news story that could harm the positive benefits of investing in a pension.”

If the Fed’s recent indecision regarding tapering quantitative easing is anything to go by, investors should not panic. We are not living in an environment where economic decisions are made quickly or aggressively.

The western financial system remains severely impaired and inflation, whilst slightly higher than in previous periods, remains quiescent. So a sudden and dramatic rise in inflation and in bond yields is not the most likely scenario,” says Crole.

Fearn agrees. “We witnessed considerable market volatility with the Fed’s ‘taper’ announcement earlier in the year, so any move by the Bank of England will need to be handled very carefully. Any rise in rates or changes to QE are likely to be implemented gradually as central banks do not want to damage the fragile recovery,” she says.

Market consensus is that any rise in interest rates – and gilt yields – will be gradual, and result in modest falls in value rather than a burst bubble.

Even if gilt values do fall, they will continue to be attractive to low risk investors who want low risk assets – after all, there was market appetite when gilts were expensive and yielding next to nothing.

This does highlight the need for those looking to take a lump sum after lifestyling to diversify however.

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 Schroders’ head of DC Stephen Bowles.

Other investment options that provide the opportunity for capturing ‘stable growth’ may well come to the fore over the next few years.” 

How dropping rates to 0.5 per cent in March 2009 affected DC schemes

At the beginning of 2008, Bank of England Base Rate was 5.25 per cent and 15 year gilt yields were 4.75 per cent. Fast forward just one year later and Base Rate had dropped to a record low of 0.5 per cent – where it has stubbornly remained ever since.

Over the last four and a half years, gilt yields fell so that by October 2012, investors were happy to pay over the odds for this perceived safety – paying a premium that is guaranteed to make a loss at redemption. And not only were gilts expensive, the average 10 year gilt yielded just 1.8 per cent – considerably less than the official measure of inflation.

Despite this expense, gilts had performed well – with demand pushing up prices – due to poor investor confidence. As market volatility abounded and cash offered next to nothing, gilts became the go to asset class for cautious investors.

As a result, investors in DC schemes that used lifestyling benefited in the run up to retirement – although they were then punished when it came to buying an annuity.

Lifestyling often involves an element of cash allocation as well as gilts and fixed interest however, meaning that pension savers approaching retirement have been punished since 2009 as cash yielded less than inflation rates, offering no real rate of return.

It is not all bad news however, a result of low interest rates, equity markets rallied significantly from the low in March 2009 – although with significant volatility. Pension schemes with equity exposure benefited as a result of the FTSE rallying from 3,512 to around 6,600 today.