Gilt yields? Get real

Middle of the afternoon and, after a day of dull trading, the brokers and
jobbers at the London Stock Exchange come alive to cheer the arrival of a
distinguished-looking older gentleman wearing a top hat. The Government Broker
strides onto the floor and announces a new gilt-edged ‘tap’ stock worth hundreds
of millions of pounds. The coupon on offer is a generous 12%. It is June 1978
and Chancellor Denis Healey is committing the Treasury to paying that debt
service charge for at least the next 35 years.

Yields of 12% and more have gone the way of the topper – or the stock
exchange floor, come to that. But while the quaint trappings and traditions may
be missed by a few diehards, no one can lament the passing of inflation-driven,
double-digit interest rates.

In May last year, the UK government issued its first ultra-long, 50-year
fixed rate gilts – but the stock with a 4.25% coupon was in such demand (not
least by pension funds) that the yield fell to 3.49% by January. Likewise, a
50-year, index-linked gilt was issued last September with a 1.25% coupon and it
soon saw its real yield plummet to a scrawny 0.38%.

But real yields as low as this create problems for pension funds and their
sponsoring companies. Not only do such lowly discount rates result in higher
than normal present values for pension liabilities, but even relatively small
basis point movements in yields can have a significant impact on the present
value of scheme liabilities (and certainly a greater impact than an equal basis
point movement off of a higher base).

When bond markets moved sharply in January, for example, the shift was
calculated to have been so great that, in a single week, the impact of lower
yields in raising scheme liabilities offset all the market gains enjoyed by
scheme assets in 2005. John Finch of HSBC Actuaries and Consultants says that a
1% fall in gilt yields on a 20-year liability would require a 20% return from
the funding assets, just to stand still.

Discount rate

Advisers SEI issued a research paper last year that criticised the use by
accounting standard FRS17 of the risk-free discount rate, arguing instead that a
company’s pension liabilities should be discounted using the company’s own cost
of capital because, just like any other capital outlay, additional pension
liabilities have to be met by recourse to the capital markets (or reserves).
“The earning assets which have to pay for pensions are those of the firm as a
whole, not just those of the fund,” it says.

But that battle has been fought and lost. Moreover, it’s not just the
accounting standards that are forcing such a ‘flight to quality’, as the
risk-based Pension Protection Fund levy favours schemes that are backed by
low-volatility assets.

Many companies have attempted to reduce their risk and liability volatility
by matching their pension obligations with comparable assets. Coupled with the
dismal performance in certain markets, the result has been a shift between 1999
and 2004 in the proportion of pension fund assets held as equities (UK and
overseas) from 75% to 67%, while the fixed interest and index-linked component
has risen from an average of 13% to 23%, according to UBS Global Asset
Management’s Pension Fund Indicators 2005.

Alan Brown, head of investment with Schroders, told the corporate
communications website Cantos in March: “Buying into real yields of less than
0.5% for 40, 50 years doesn’t help to make the pension fund proposition
affordable. I think it’s another glorious case of the unintended consequences of
regulation.”

More ultra-long gilts issuance would help, says Finch, at least to an extent.
“Extra supply should help soak up the cash looking for a home in this market,
thereby meaning that yields will be less likely to fall further.” However, rises
in yields will probably cause more buyers to emerge, putting the lid on rates,
Finch adds, noting that academics estimated earlier this year that, even if all
gilts were long, there still wouldn’t be enough stock to meet demand.

Higher rates

Sure enough, interest rates have been edging up in recent weeks but, as David
Smith, Sunday Times economics editor, wrote in Professional Investor recently,
the pensions problem is “the classic Catch-22. Savings will increase because of
the need to make provision for retirement, but the rise in savings will have the
effect of keeping long rates at levels that mean poor returns for pension funds.
The conundrum, I fear, is not going to go away.”

Finch at HSBC sees it another way, but has the same conclusion. “In the end,
because of current actuarial valuation methodologies and the need to protect
downside, there is likely to remain an ‘insurance’ premium at the long end of
bond markets and so the yield curve will remain inverted for some time.” As we
go to press, long gilts are yielding 4.3%, which Finch says is reckoned still to
be well below the historic ‘fair value’ of about 5%.

Pension scheme trustees and their sponsoring company FDs may be hankering for
a return to the high-yield days of the Government Broker after all, but we’re
probably more likely to see a return of the top hat.