Yields on the way up

Blog 02 Mar 2021 By Simon Cohen

So, it has happened at last.  For many years we have all been talking about how gilt yields could not go down any lower and yet, they continued to decline.  It has now finally happened that they have started to increase.   

So, why have gilt yields started to increase?  

Given all the loose monetary policy (e.g., quantitative easing) in response to COVID-19, the markets now believe that inflation will increase.  As we have had loose monetary policy for many years, you may ask why the markets believe inflation will increase now.  The key difference is the fact we now also have very supportive fiscal stimulus policies in place globally.  The markets believe that the combination of these will lead to inflation.  With sky high government debt, there is also the view that the government would be keen to have some level of inflation (but not too high) to erode the real value of the debt and help it in its financing. 

When inflation increases, typically gilt yields increase as the real value of gilts is eroded, so investors demand a higher level of yield to compensate for this. 

So, what does all this mean for pension schemes?   

There are several areas to consider when answering the question.  Firstly, growth assets.  The initial response in equities was a fall in the markets, particularly high growth areas such as technology stocks.  Other markets have fallen as well, but now seem to be stabilising a little.  In the medium to long term, typically, equities do well in an environment where there is inflation, so long as it does not become too high and volatile.   

The next is bond assets; as gilt yields have started to rise, gilts and Liability Driven Investment (“LDI”) have started to fall in value.  This in itself may appear to be bad news.  However, to look only at the asset side of the pension scheme misses a major part; the liabilities.  The liabilities themselves will actually fall as gilt yields have continued to rise.  Liabilities will then increase a little due to inflation increases.  However, typically, a scheme’s liabilities in respect of inflation have caps and collars in place and so the gilt yield rise will dominate, and the liabilities will ultimately fall.  The extent to which the funding level improves will depend on how well hedged a scheme is, i.e., how much LDI and bonds it has.  With low levels of hedgingthe funding level will improve a lot (all else being equal); with high levels of hedging the funding levels will improve a little, if not at all. 

So, what should trustees be doing, given the potential improvement in funding level? 

Trustees might want to think about de-risking their investment strategy, if they can afford to, and take advantage of the situation.  They might also want to think about setting up a trigger structure such that, as yields rise even further (if they do), they de-risk further; such a strategy is typically called journey planning. 

In summary, yield increases are likely to be good news for pension schemes. Trustees should be looking to take advantage of the situation and look more closely at their investment strategy. Trustees should contact their investment consultant who should be able to provide advice based on the specific scheme circumstances 

Simon Cohen

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