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    Top of the market: Are we nearly there, yet? by David Cule
    Date Published
    28 February 2017

    Like the plaintive refrain of the restless child in the backseat, “are we nearly there, yet?” has been the question posed by a growing number of people belted in for the 21st century pensions journey.

    If your family were anything like mine, the response from behind the steering wheel to each repeated entreaty was audible rolling-of-the-eyes or hissed-through-gritted-teeth: “not long now.”
    Of course, the not-long-now was a time-traveller’s calculation of infinite duration.  At times, that’s how it feels now.
    The government has just sold two billion pounds’ worth of 40-year duration, index-linked (inflation-proofed) bonds, or gilts.
    What’s remarkable is that investors have put down their money in the clear knowledge they will get less than half back, with an issue price of £220 per £100.
    In real terms, they have spent £220 to get back £100 when the gilts mature in four decades. Plus a fiver or so of interest each year.
    By any reckoning, that doesn’t look like a good deal. Buying a house now in the knowledge you’ll only get half what you paid for it? Over the long-term, it doesn’t make sense.
    Welcome to the world of gilts. It might be that buyers are simply looking to sell on. The offer was oversubscribed by five times, so that’s always a possibility.
    So who are the buyers (and why)?
    Ownership of gilts is roughly spread across four classes, institutions, such as insurers and pension schemes, overseas buyers, the Bank of England – through quantitative easing - and other financial organisations.
    It could be argued that the first three classes are not “value” buyers in the sense of the above analysis.   Overseas buyers might be more interested in the relative value of sterling against other currencies and use these stable instruments as a home for this part of their allocation.
    So whilst they may not be especially keen buyers they may not sell on yield-based valuations and so (effectively) limit the supply side.  For now, we know BoE is not a seller – they may even remain a buyer for a while – and, again, this decision is not based on yields.
    Next, we can look at the insurance and pension fund market.  Are they yield-sensitive?
    It is arguable they are not.  Insurance companies must “match” their liabilities – and those that want to issue more policies will need to chase down matching assets, so arguably this debt is just raw material for their production line, which they will pass on to the consumer (which seems to provide an almost infinite demand for buy-out products, aided by transaction agents selling the miracle cure).
    Similarly, pension schemes measured on a gilts or gilts-plus approach (which includes company accounting standards) are trapped in the same place. Unless they are willing to run a mis-measurement reporting risk, buying such debt means the measured funding level will not worsen, irrespective of market movements.  So again, these bodies are not sellers (and indeed are likely buyers at almost any price)
    With at least three-quarters of the market participants potentially not yield-sensitive and unlikely sellers, how does a value judgment that this is an unsustainable place, play out?
    This is particularly so in our world of pensions schemes , which have insurance-like liabilities but no strict requirement to hold explicit investments and/or risk capital.
    Ultimately, this question goes to shareholder value within the sponsor of the pension schemes.  The sponsoring company directors need to see the underlying value in allocation of capital to either  the pension scheme, the business or the shareholders.  If this applies to a scheme that will almost automatically buy negative yielding debt, then it is a very important question.
     In favour of such an approach is that reporting of the scheme and cash demands of the scheme will be stable (which serves to improve shareholder value) but higher in the short- term (which serves to reduce value).
     It is also consistent with a theoretical approach that if a shareholder wanted to take a risk-bet against a fixed liability, they could do so themselves (by borrowing money and investing in risk assets directly.
    Alternatively, if the scheme is seen to be not that large relative to the sponsor, then it may be a reasonable management call to say that such debt is not good value and alternative investment homes for pension money could be sought.
    Finally, there are additional circumstances why a scheme (rather than the sponsor) may seek additional return.
     Remembering that the first order risk for any scheme is the survival of the sponsor,  a good covenant does mean that risk may well be acceptable to the members as the sponsor should be there to pick up any slack.
     Additionally (although The Pensions Regulator and the Pension Protection Fund doesn’t like to admit this) the existence of the PPF also allows some risk to be acceptable to members (albeit such risk may be reflected in the levy calculation). Incidentally, these ideas are explored further in our recent note on the discount rate quandary
    Gilts are certainly good business for the government. Collecting £4.5bn now, with a promise to pay £2bn for it in 40 years’ time, must delight the Treasury. No argument with that.
    So we’re still behind the wheel and on the road. As I’ve emphasised in previous blogs, there’s much to be said for managing the journey ahead for your pension scheme, instead of seeking an exit route as quickly as possible. This latest gilt auction has, at least, provided a milestone did-you-see-that?” moment to consider.
    The views and opinions expressed in this article are those of the author and do not necessarily reflect those of the Punter Southall Group.

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