Photographer: Chris Ratcliffe/Bloomberg

There's a 'Negative Feedback Loop' Bedevilling U.K. Pension Funds

How pension funds and insurers could further bid up U.K. government bond prices.

Government bonds are a bigger trap than you might think for yield-hungry long-term investors.

U.K. pension funds and life insurers could be hit with a double whammy of pain as ultra-low government bond yields intensify funding shortfalls and spur investors to match their ballooning liabilities with longer-dated assets, creating further demand for sovereign debt and pushing yields even lower.

U.K. pension funds and life insurers have been under siege for years as low government bond yields — typically the favored source of income for such funds — have generated significant funding headwinds while pension liabilities have risen.  

Now, the Bank of England's quantitative easing program and a shrinking pool of longer-dated assets are leading bond prices ever higher, further challenging the ability of investors to finance long-term obligations to beneficiaries.

A failed Bank of England reverse auction last week, for example, caused longer-dated securities to abruptly fall to new record lows,  with the yield on 10-year gilts currently hovering at 0.53 percent.

Source: Bloomberg

But there's another market dynamic that could exert more downward pressure on interest rates and further challenge returns for long-term investors: asset-liability matching. Put simply, large funds with fixed-income liabilities, such as pension and insurance funds, need to grab more long-term U.K. government bonds to hedge growing liability risks just as prices rise. 

That's because as U.K. rates fall under current market conditions, such investors — faced with the need to hedge their increased liability costs by rebalancing the duration exposure of their portfolios — are being forced to grab yet-more longer-dated gilts, which will lower yields ever-further, reckons Renuka Fernandez, senior analyst at TD Securities Inc.

"If the pension funds and insurers are running asset/liability duration gaps on their balance sheet then a fall in rates will cause the liability side to rise faster than the asset side," she says.  

Toby Nangle, London-based head of multi-asset allocation at Columbia Threadneedle, explains the dynamic further.

"The present value of estimated pension payments are discounted by accountants and actuaries using long-dated yields," he says. "And so the asset-liability mismatch that most (but not all) schemes are running will have likely led to widening pension deficits in recent weeks as the estimated present value of future pension obligations has risen faster than asset values."

Unless such funds offset risks by taking exposure in the market for interest rate swaps, a growing number of pension funds are likely to increase their demand for longer-dated bonds in the coming months, in a bid to hedge their growing liabilities.

"To keep the asset-liability gap roughly constant the pension guys will be forced to buy more assets to duration-match their liabilities," says Fernandez. "This, in and of itself, will force bond prices higher (and rates lower), widening their asset-liability gaps once more, forcing them again to buy bonds (or receive on swaps or enter into receiver swaptions) as prices are rising  — thereby creating a self-reinforcing negative feedback loop."

Judging by the muted activity in the swaps market over the past month, the duration-hedging activity of some pension funds and insurers will intensify in the coming months, thereby placing further downward pressure on long-term rates, Fernandez concludes. She suggests the 10-year gilt yield could fall below 50 basis points by year-end, thanks to the activity of such investors, as well as the structural shortage of U.K. government bonds and the BOE's stimulus program.

The U.K. forward market for the 10-year gilt is less bullish:

UK forward curve
Source: Bloomberg

The Bank of England could in theory reduce duration pressures on pension and insurance funds by intervening at the short-end of the yield curve — or, entering the derivatives market directly, as some analysts have already suggested. 

In any case, U.K. pension funds with international exposure have received some post-Brexit relief, Nangle concludes. 

"The non-U.K. assets of pension schemes may well have kept up as sterling's post-Brexit collapse will have boosted the sterling value of overseas assets," he says. "Schemes that don't invest all of their assets in long-dated bonds or haven't used long-dated interest rate swaps find that their deficit hasn't grown since Brexit if they have large proportions of non-sterling assets."

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