Trustees challenged by gilt yields
3rd September, 2019
Between April 2019 and August 2019, the UK 10-year government bond rate has fallen from 1.27% to 0.43% and 20-year rates from 1.77% to 1.0%. This has mainly been driven by a slowdown in economic growth and the desire for safe assets.
It is not just the UK where yields have seen dramatic declines – it is happening across the globe. The 10-year US Treasury yield fell from 3.24% in November 2018 to 1.46% in August 2019. This huge decline can be explained by the US Federal Reserve (Fed) reducing its benchmark rate by 0.25% on 31 July (the first reduction since 2008) and also deciding to end the process of shrinking its balance sheet, known as quantitative tightening, two months ahead of schedule. Large bond managers say it would not be impossible for the Fed to reduce rates to 0%; they are currently 2% to 2.25%. Elsewhere, in August 2019, German 10-year yields are -0.71%, and the Japanese 10-year yield is -0.29%. It seems unlikely that UK rates will go as low as Germany or Japan, but it highlights that investors are willing to accept negative returns.
It is estimated that $16 trillion or 1/3 of the global bond market has negative yields and if held to maturity investors would generate a loss. The reason for this strange occurrence is because investors are expecting a global recession due to:
- the ongoing trade war between the US and China,
- Brexit and
- a slowing Chinese economy which has affected many Europe counties such as Germany which exports a lot of goods to China.
As investors are nervous of future global growth, they are putting their capital into the safest assets they can find i.e. bonds, despite the negative yield.
Negative yields in Europe have created some strange events. For instance, Jyske Bank, Denmark’s third largest bank has launched the world’s first negative interest rate mortgage at -0.5% a year. Every month debt is reduced by more than the amount people pay. The bank is able to offer this because it can get even cheaper loans (i.e. more negative rates) and is simply passing the benefit on to its customers.
In Switzerland, the bank UBS has told its wealthy clients that it will introduce a charge of 0.6% a year if they deposit more than €500,000. So, rather than earning interest they will have to pay to hold cash. Being charged for bank deposits might soon become the norm in Europe.
A key tool central banks use to encourage growth when there is a recession is to lower rates. But considering how low rates currently are for many developed economies, they will not be able to pull this lever. They will need to find alternative solutions to avoid a prolonged recession and encourage growth. Given that monetary policy does not seem to be working, as low rates has not seen an increase in growth or inflation, then perhaps more fiscal stimulus (lower taxes) will be needed.
What should trustees do?
The recent decline in yields poses a question for defined benefit pension scheme trustees. Should they increase the level of interest rate hedging even though rates have fallen? This has been a key challenge for trustees over the last 10 years as rates have declined. While hedging won’t offer the same benefits as it did previously, because yields are lower, it should provide trustees with a more stable funding level.
The decline in gilt yields has pushed transfer values to even higher levels, tempting members even more to leave their scheme. Trustees should be aware of the potential for more transfer requests and ensure their scheme remains sufficiently liquid to meet higher demand.
It seems that low rates are here to stay. With many central banks likely to reduce rates further to encourage economic growth, gilt yields may fall even more. Trustees need to be aware of how their scheme will be affected and consider increasing the level of interest rate hedging and cash for transfer values.