British pensions did not understand what they were buying
There have been two underlying problems for corporate defined benefit pension funds. The first is that companies don’t want them because they increase earnings volatility and have been underfunded for many years, often requiring a cash injection. The second is that successive governments have used pensions as a piggy bank. Between the removal of the dividend tax break in 1997 and the announcement of a 2020 change in the calculation of inflation for inflation-linked bonds to a method that suppressed reported inflation numbers, the government was very happy to stuff savers, pension funds included, with quantitative easing. The result was that falling long-term interest rates massively increased the present value of pension fund liabilities.
Hence the resumption of investments based on the liabilities of pension funds. The idea was simple: in addition to asking companies for more funds to make up for any lack of funding, pension funds were borrowing money to buy assets. From an actuarial and regulatory point of view, the assets they needed were various combinations of very long-term bonds, mainly conventional government debt and inflation-linked bonds (called linkers in the UK). Pension funds typically only compensate pensioners for inflation below 5%. This still gives them a potentially significant responsibility. Hence the huge demand for linkers.
Frankly, I’m not convinced that anyone – fund managers, trustees, consultants, regulators, companies or the wave of large and small investors who thought it was a good way to hedge against rising inflation – knew what he was buying. One clue is that investors were picking up long-term linkers even when real returns were extremely negative. Yields bottomed late last year when the real yield on five-year bonds fell below minus 4% and that on 30-year bonds fell below minus 2.5%.
Let me explain to you why this is absolutely insane. Using this last example, this means that investors pay the government 2.5% every year for 30 years to receive this payment from inflation. But they don’t really get the rate of inflation in return, at least not initially. That is not how these bonds work. What they get is the bond’s coupon rate plus, very roughly, the last reading of the inflation index divided by the inflation index at the time the bond was issued. What they also likely get is an increase in the face value of the bonds by an amount that also depends on this inflation index ratio. (In the US, holders of TIPS, the equivalent of flashcarts, do not benefit from the coupon adjustment, but they do have some downside protection, since TIPS are redeemed at par).
This causes some problems. When coupons and real yields are very low, the performance of the inflation-linked bond will be dominated by long-term interest rates — and the duration of inflation-linked bonds is very high. (Duration is simply a much more accurate way than maturity of seeing how well a bond’s price responds to a change in interest rates. The longer the duration, the more they fluctuate.) Even after the huge sale, the current duration of the iShares UK index fund, for example, is the same as that of a 20-year UK government bond. And when you start with roughly zero inflation, a sharp rise in inflation will have a huge impact on the assumed inflation rate at the time of repayment. This is why higher inflation actually leads to greater supply. In English, more obligations.
As a result, the initial pension fund portfolios were both incredibly valued and leveraged, which is generally not a lucrative proposition. Still, given pressure from administrators and regulators to improve funding levels, this should come as no surprise. But while the rise in longer-term yields quickly improved pension funding positions, it also meant that the leverage they had applied to their bond portfolios meant they suddenly had too much money. obligations. This meant they had to sell. It’s not too difficult with normal gilts. But who do they sell linkers to? Pension funds are pretty much the ones that set prices in the inflation-indexed market on both sides of the pond. Since they’ve all been in the same boat, there really wasn’t anyone to fill the void, so the sale spawned more sales until the Bank of England showed up.
Besides the perils of ignorance, three things flow from this saga. The first is that the acute phase of the pension problem can turn into a chronic phase. Inflation shows no signs of abating. Both short-term and long-term interest rates are headed higher, meaning even more adjustments in repo bond portfolios (read: sell). Also, I can’t help but think that rational people would cash in their pensions, which means less money for pensions to invest and even more to sell. That 5% inflation cap now looks very meager compared to buying inflation-linked bonds outright. Linkers have gone down so much that you can now buy them with positive real returns and until 2030 you get the highest RPI.
Which brings us to the third point. While many will object that the markets believe inflation will fall dramatically, there’s a pretty good reason why market expectations have told you next to nothing about where inflation is headed. These inflation expectations on the markets are called the equilibrium rate. They are simply the yield of, say, a normal 10-year bond minus the actual yield of the inflation-linked bond. If aggregate bond yields are suppressed by all the things I’ve talked about before, and real yields have risen, equilibrium rates will fall by definition – and therefore can’t tell you anything interesting about future inflation .
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Richard Cookson was Head of Research and Fund Manager at Rubicon Fund Management. Previously, he was Chief Investment Officer at Citi Private Bank and Head of Asset Allocation Research at HSBC.
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