Consulting » Getting in a twist

WHEN BEN Bernanke, the chairman of the Federal Reserve, announced the so-called Operation Twist in September, he created a real dilemma for UK and European pension funds.

The goal of Operation Twist, in which the Fed will swap its short-dated debt purchases for a basket of longer-dated debt, is to lower the yield on long-term debt. Bernanke’s thinking is that the Fed will achieve two things by forcing down longer-term interest rates. First, the move will push investors to move money out of long-dated bonds and into riskier, but also higher-yielding assets, such as corporate bonds and equities. Second, the Fed will also drive down the cost of mortgages, which are predicated on long-dated bond yields in the US.

Both of these things are supposed to stimulate the ailing US economy. Lower mortgage costs means that more money will end up in the consumer’s pocket. Meanwhile, more money going into equities creates the “wealth effect”, which is much sought-after in the US, as Mike Lenhoff, chief investment officer with Brewin Dolphin, notes. Because more individuals invest in the stock market in the US, rising equity prices make people feel that they are getting ahead. Equally importantly, Lenhoff points out, falling bond yields increase the net present value of the dividend stream, which, of course, is not the same thing as actually pushing up dividend payouts. However, it does create positive value.

“Operation Twist looks very likely to push up the present value of dividends and asset values – at least by a bit – and that will stimulate the US economy,” says Lenhoff. That is a good thing for pension funds everywhere, since it could help to generate a more positive feeling in the global economy by raising those Keynesian “animal spirits”, as well as lifting fund investments in US assets.

However, on the negative side of the ledger, there is the indisputable fact that driving down long-term yields also comes with the inevitable consequence of driving up pension fund liabilities by a disproportionately large amount. This happens when the discount rate in scheme-funding calculations is lowered, as such a decrease also automatically increases scheme liabilities.

Jittery markets

At this point in time, the great unanswered question is whether the increase in scheme liabilities set to be the result of Operation Twist will be offset by corresponding increases in asset values.

“In normal conditions, you would see falling bond yields accompanied by rising equity values. Lower bond yields influence fair value calculations on equity, making the fair value higher than it might otherwise be, and the markets then chase prices upwards,” says Lenhoff.

As the European sovereign debt crisis continues to smoulder and flare, however, equity markets in both Europe and the US are so jittery and volatile that any small upward movement is likely to get snuffed out in yet another panic. Lenhoff also points out that a climate of high volatility tends to scare investors away from high-risk assets.

Moreover, high volatility lowers the return from risk assets on a risk-adjusted basis. And this phenomenon occurs even in the calmer world of pension fund investment decision making, in which managers usually try to look beyond the immediate panic of the day’s latest adverse headlines. In turn, this means that the higher volatility encourages a move to more defensive, but lower-yielding assets. And this counter-productive trend can create considerable headwinds for Operation Twist and the outcome for which Bernanke is clearly hoping. Meanwhile, UK pensions fund trustees and scheme sponsors are going to have to wrestle with higher funding liabilities. In short, what Operation Twist gives pension funds is a somewhat doubtful positive and a very certain negative.

As Colin Robertson, global head of asset allocation at Henderson Associates, remarks: “Pension funds were probably not uppermost in Ben Bernanke’s mind when he initiated Operation Twist.” In the UK, much shorter-term periods for fixed-rate mortgages tend to be the norm, whereas the foundation of home ownership in the US is the 30-year mortgage.

However, Robertson points out that mortgages in the US are already highly affordable, so making them still more affordable is probably not going to have a huge impact on consumers.

“The real influencing factor in the US mortgage market at present is not interest rates; it is negative equity and that persists despite Operation Twist,” claims Robertson. The other issue at stake is the fact that companies will now be constrained by their soaring pension scheme liabilities, even though they might be tempted to borrow as money becomes ever cheaper. “If they are hurt by their pension funds, then that will have a bigger impact than lower borrowing costs,” concludes Robertson. ?