By Toby Nangle
This month saw the Bank of England (BoE) reduce its rather aggressive wage growth forecast for the year after data indicated that UK pay levels had fallen. This, coupled with the fact that the BoE started thinking aloud about the spare capacity in the labour market, has resulted in the market pushing back expectations of the first interest rate hike out to 2015.
Governor Mark Carney has also spoken of interest rates peaking at much lower levels than they would have in yesteryear.
We are less certain that the new normal for rates will be as low as suggested by Carney and have therefore, in our multi-asset portfolios, been reticent to lock our clients’ money into the UK government 10-year gilt (yielding just 2.4%). In fact, in our asset allocation matrix we currently don’t favour any government bonds with such duration.
However, we view the very long end of the UK curve (25 years +) differently, particularly with regards to our UK defined benefit (DB) pension schemes clients that are in de-risking mode and have a huge demand for long-dated duration. Indeed, data from the UK’s Pension Protection Fund shows that UK DB schemes are collectively around 15 years of duration short on a liability base of £1.2trn.
The problem is that valuations are not hugely compelling for conventional long-dated gilts. You can see why this presents a dilemma for pension schemes that need bonds to be both long in duration and attractive in terms of the yields they offer.
There is one exception to the rule, however, and it comes in the shape of one of the oldest bonds in the market, issued back in 1932 – a perpetual UK government bond known as the ‘War Loan’. It carries yields comparable to those seen pre-crisis and also fulfils a very traditional role of bonds in providing negative correlation with equities.
The War Loan has a modified duration (price sensitivity to yield change) of around 25 years, which is around the same as the longest conventional UK gilts. Compared to such conventional bonds, however, it yields around 70 basis points more. We believe the reason for why this bond rewards investors more handsomely is that it is callable by the government at par (when the yield hits 3.5%). In the event of a substantial bond rally, for example, the total return would be capped at just over 11% over a one-year holding period; this would compare unfavourably with the uncapped returns of another, more conventional long-dated UK government bond.
We do not see such a scenario as likely, however. In fact long-dated bonds would only rally substantially if the market moves to discount the ‘Japanification’ of the UK and the West more generally, ie a combination of deflation and low growth. This economic outcome is by no means our base case. Instead, we see good prospects for medium-term economic growth, and our measures of spare capacity in the UK and the US are consistent with an environment in which wages grow and central banks raise benchmark interest rates.
In our opinion, valuations are not compelling for long-dated, conventional gilts but we see the additional 70 basis points of yield that comes from buying a callable bond to be sufficient to change the economics. With yields comparable to those seen pre-crisis, the War Loan looks like it could fulfil the positive return and negative correlation to risk assets that bonds used to deliver in ‘the old days’. As such, one of the oldest bonds in the market appears indeed to be an old-fashioned bond, and one that is perfectly suitable for today’s environment.
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