A gilt storm brewing?

Rising interest rates create winners and losers amongst pension savers. Emma Wall foresees losers aplenty if default strategies do not adapt

Interest rates will rise – it’s a case of when not if. And despite Bank of England Governor Mark ‘The Unreliable Boyfriend’ Carney changing his mind with the seasons, we are unarguable getting closer to the inevitable date when the Monetary Policy Committee raises base rate.

Given that gilt valuations are inversely correlated to interest rates, any increase in interest rates will present risks to supposedly secure assets within pension schemes. The second quarter of 2011 saw 15 year gilts rose in value by more than 20 per cent – if gilt price falls resulting from increases in interest rates are even a fraction of the order of this increase, lots of pension savers are going to feel some pain. No wonder  the Financial Conduct Authority has recently been warning retail investors about the risks associated with corporate bond funds.

The extent of this risk to supposedly secure assets will depend on the speed and extent of increases. Given the fragility of the recovery, we will not see the drastic rate changes seen at the height of the financial crisis, but there will be movements.

The Bank of England’s MPC voted to hold rates again this month, at the record low of 0.5 per cent where it has stubbornly sat since March 2009. But where the vote once was unanimous, it is now divided. Minutes of the MPC meeting held on September 3 and 4 reveal a 7 to 2 split regarding interest rates. Members Ian McCafferty and Martin Weale voted against the proposition, proposing to increase Bank Rate by 25 basis points. It was these two who voted for a quarter point rise last month too – before then no one had raised their head above the parapet since July 2011.


In June Carney gave the clearest indication of where and when interest rates will be over the next couple of years, saying the new normal for interest rates would be 2.5 per cent, like to be reached by early 2017. Just 12 months before the dramatic cut to 0.5 per cent in March 2009, the Bank of England had set base rate at 5.25 per cent – but Carney said that too much had changed for rates to return to this level.

Carney subsequently backtracked on this, causing MP Pat McFadden to liken him to a flippant lover, but the split vote proves the tide has turned. With UK unemployment falling to the lowest level since 2008, and inflation well below the Government target of 2 per cent the pressure is on to raise rates.

Standard Life Investments chief economist Jeremy Lawson holds the near consensus view that the Bank will begin raising interest rates in the first quarter of 2015.

“Although wage growth is subdued, the economy, housing and labour markets are improving rapidly enough that there is no longer need for emergency policy settings,” he explains.

“There also seems to be a growing recognition on the MPC that beginning the tightening cycle earlier will allow the removal of accommodation to occur more gradually. The risks to that view are probably more towards a later tightening, particularly if underlying wage growth fails to pick up meaningfully over the coming months, or political uncertainty increases.”

But as well as bad news for mortgage holders and credit card spenders, rate rises are potentially disastrous for mature pension schemes.

In July the Financial Conduct Authority issued a warning to retail investors about the risks associated with corporate bond funds, highlighting the lack of liquidity, the risk of defaults – and potential interest rate rises.

“Interest rate movements have an impact on corporate bond and fund unit prices,” the FCA warns. “As interest rates rise, bond prices fall. This is the key difference to deposit accounts, where the capital value is constant.”

You would have had to be a pretty shoddy investor not to make money in the bond markets over the past couple of decades. In fact 10 year gilt yields have fallen steadily since the mid-eighties. In the second quarter of 2011, 15 year gilts rose in value by 21 per cent (pull quote) – add to that a yield of 5 per cent and it’s an attractive total return for just six months investment in a supposedly secure asset class.

Thanks to regulations that insisted pension funds match liabilities with bonds, pension funds have piled into US, UK and European long dated sovereign bonds over the last two years at a time when the market was peaking.

Our European counterparts in Demark and Sweden have recognised the risks and chosen to charge the way liabilities are calculated to reduce this rate-free-risk asset purchase.

But those UK schemes who have benefitted from gains over the past decade are stuck with a hefty bond allocation that threatens their portfolio returns.

Defined contribution schemes that follow the glidepath structure to retirement are particularly at risk from bond prices falling as they generally invest heavily in long bonds as a hedge against changing annuity rates.

Fund manager James Tomlins of bond giant M&G says we are entering a new era for interest rates in the developed world.

“The extended period of ever looser monetary policy is starting to draw to a close. Having benefited greatly from falling yields and tightening credit spreads, the move to a more hawkish cycle will create many more headwinds and challenges when it comes to delivering returns for many fixed income asset classes,” he admits.

Now: Pensions have recognised the risks and made adjustments to its master trust – and is urging other pension providers to do the same.

Now: Pensions head of proposition Rob Booth says all schemes should review and amend their glidepath structures as soon as possible, and warns that those running contract based pension arrangements such as GPP’s are in a particularly difficult position if all members, active and deferred, are required to sign a consent form allowing their pension fund to be switched out of an inappropriate default strategy – as this may slow down the trustees ability to act when bond prices start to fall.

“Many investors nearing retirement who are not planning on purchasing an annuity are likely to be invested in inappropriate asset classes,” says Booth. “With the forthcoming flexibility in how members take their retirement benefits, this annuity hedge will become redundant for many, and unless trustees and scheme sponsors take action to revise their glidepath asset allocation, members could very well be disadvantaged.”

Why Rate Rises are Not all Bad

Aegon investment director Nick Dixon says that the FCA’s note on fixed income investments should be seen in the wider context of what is happening in the economy. He believes it’s message is not all bad.

“The FCA notes that rising interest rates could reduce the capital of investors in the short term but interest rates will rise as the economy strengthens – which itself aligns with ongoing pick-up in companies’ financial performance and their ability to service debt obligations,” he comments. 

“As a result rising rates could be a signal of reducing corporate risk and reduced likelihood of default on their debt. Against this backdrop pension savers can take a more rounded view and corporate bonds are likely to form a significant part of many people’s fund.”

June’s Global Markets Overview paper from Towers Watson revealed it too was not ready to write off bonds entirely either. Its global investment committee said that while the return from bonds is low it is still reasonable relative to very low-yielding cash, comprising the starting yield and modest upside as the path for cash rates is revised somewhat lower.

The paper also highlighted that bonds provide attractive returns in scenarios where growth or inflation disappoint expectations on the downside, which the committee consider more likely than upside surprises.

“Whilst bonds provide low expected returns under our base case, they are still above cash and offer attractive downside protection,” it concluded.

JP Morgan Asset Management european head of strategy Paul Sweeting points out that pension scheme liabilities are specifically sensitive to interest rates movements, as well as the bonds that they hold – but in this case rising rates will have a positive effect.

“A rise in rates will cause the liabilities to fall,” he said. “One way of thinking about this is to recognise that if the cash flows from a bond portfolio are a good match for the liability cash flows in the scheme, the price is not important.”
“In fact, for many pension schemes – which hold assets other than bonds – a rise in rates would be a good thing.  The value of the liabilities would fall by more than the assets, significantly improving the funding level.”
In the UK, pensions are inflation-linked – to an extent, anyway.  This means that for modest levels of inflation it is the real yield that is important when considering the liabilities, not the nominal yield.  In other words, if nominal bond yields rise but so do inflation expectations, the value of liabilities might not change; but the value of a typical bond portfolio could well fall.  One way of hedging against this risk is to hold index-linked gilts, or to use inflation swaps.  However, inflation protection is very expensive to buy at the moment, with real yields hovering around zero.  This means that alternative sources of inflation-related cash flows are finding favour, infrastructure in particular.
Finally, the market is expecting base rates to rise at some point, so these increases are already priced into bond yields.  Bond yields may creep up, but with subdued inflation, limited growth in Europe and geopolitical risk around the world, we are unlikely to see bond yields rise significantly in the medium term.