Institutional investors are increasingly able to sigh with collective relief. Funding gaps are beginning to ease as risk assets continue to rally and yields begin the slow process of normalisation. For defined benefit (DB) pension schemes, this offers the chance to lockin gains by de-risking and insurance companies become forced buyers of slightly less expensive assets.
“Most triggers that exist for de-risking and liabilitydriven management have been put in place by a fairly concentrated group of consultants. Logic says they will be advocating similar triggers to their clients. If this is the case yields could correct sharply, maybe within seconds or 24 hours.”
Roger Mattingly
As rosy as this picture might look, there will be winners and losers in the race to de-risk as the flood of money into bonds has its own effect on the yield path. “De-risking could affect yields on a potentially aggressive scale,” says Hugh Nolan, chief actuary at JLT Benefits Solutions. Post-Lehman the nominal yield on 30-year gilts hit a low-point of around 3%, but is cur- rently edging towards the 4% mark again, hitting 3.63% on 9 December 2013. Meanwhile, the FTSE 100 has increased 50% over the last five years. Pension schemes have already begun taking advantage of the improved conditions to derisk, something they are increasingly pressurised to do not just by the regulators, but also by sponsoring companies who feel the impact of deficits on their balance sheets. So far, the rally in risk assets has been the main driver of de-risking and the impact that is having on bond yields is already apparent. According to Mike Amey, portfolio manager at Pimco: “De-risking is not just about the level of gilt yields. It is also about what is happening in risk assets. Looking at this year, one of the reasons UK long-dated gilts have performed well versus short- and medium- dated bonds, with yields currently 25 basis points lower than comparative US bonds is because pension funds have been de-risking.” Looking forward however, interest rates are expected to normalise further, which should push more institutions, many of whom remain reticent to buy at today’s prices, into the bond markets. And not just because higher rates decrease prices. Nolan calculates an increase of just 0.25% in the underlying corporate bond yield could decrease deficits by around a third, shaving over £50bn off the combined deficit. “Arguably, the gap between corporate bonds and gilt yields should be fairly stable in terms of yield curve moves,” he says, “so it’s not stupid to suggest a 0.25% increase in gilt yields would be matched by a similar increase in corporate yields and therefore have the same £50bn+ impact.” Many schemes have yet to de-risk, but the demand for advice on putting flight paths in place remains high, as it does for liabilitydriven strategies and buyouts. The expected increase in funding levels as yields rise, bond prices fall and risk assets improve further as growth takes root in Western economies, will add to the already considerable pent-up demand for bonds.
As yields pass key trigger points, that demand could lead to a flood of money into the bond market. Unless enough supply hits the market simultaneously, that demand could in itself create a significant and detrimental correction at those trigger points. The 30-year gilt level, for example, has proven resilient as an indicator for many years. “When the 30-year gilt yield is back up to 4% we will see an acceleration in long-dated gilt buying,” Pimco’s Amey argues. “As yields go higher, demand gets proportionately greater. Relative to supply, there is already a wall of money in the inflation-linked market. The 30-year UK inflation-linked yield is 1.6% below that of 30-year US inflation linked yield because demand is more concentrated here. “We will likely see some buying before yields hit the 4% mark,” Amey continues. “It will not be much more complicated than money coming into gilts with every quarter or half percent yield rise.” The complexity of the triggers DB pension schemes are following is a critical factor in determining how large any correction could be. Amey’s suggestion of a relatively simplistic approach is supported by a belief that relatively few triggers are being tracked. If this is the case, it would concentrate trading onto a few key factors and time-periods, exacerbating the market impact.
Opening the flood gates
Roger Mattingly, director of PAN Trustees and president of the Society of Pension Consultants, believes there could be as few as six key triggers. “Most triggers that exist for derisking and liability-driven management have been put in place by a fairly concentrated group of consultants,” he argues. “Logic says they will be advocating similar triggers to their clients. There will be some degree of customisation, but there will be similarities in the key triggers.” If this is the case, and especially if a significant proportion of money migrates on an automated basis, yields could correct sharply in a very short space of time, “maybe within seconds or 24 hours,” Mattingly estimates. “Some investors will therefore be buying into more expensive bonds if they are even a few microseconds late.” The market impact on transaction costs could be mitigated to some extent by the use of individualised trigger points tailored to a scheme’s specific cash flow. Doing so would provide a unique yield, allowing investors to move away from the headline rates. “That offers massive protection and can make a material difference in terms of transaction costs,” argues Mark Humphreys, head of UK strategic solutions at Schroders Investment Management. “This is an underexplored avenue and is not expensive. Most people are not using bespoke triggers. Investors will react on common market triggers and will suffer from yields bouncing as buying comes in at those levels.” The bouncing effect also threatens to leave those targeting more ambitious triggers exposed if they have not de-risked in the event of a wider market correction, especially those caused by ‘tail’ events.
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