After months of poorly performing gilts numbers, there are eventually signs that government bond yields might finally be increasing. For trustees, this means it is time to prepare for scheme de-risking and be prepared to act quickly to take advantage of this window of opportunity.
UK 10 year government bond yields have now broken through 3 per cent for the first time since 2011, Paul Carney’s much trumpeted Bank of England’s introduction of forward guidance on interest rates and a “sharp increase” in the manufacturing and construction Purchasing Managers’ Indices and other indexes such as the service sector business survey all support the growing expectation that longer-dated gilt yields will continue to rise.
Trustees should consider de-risking and buying bonds but only if they believe that the gilt yields increase in the last few months (which has meant that bonds became cheaper and schemes’ funding gaps became narrower) and that interest rates are going to be lower for longer, make it sensible to move into more gilt-type investments. One of the issues will be that as Trustees start to increase demand and in so doing will constrain yields from climbing particularly high.
The decision whether Trustees should increase their investment in gilts depends upon their risk journey plan and how they want to balance investment risk against sponsor contributions. Or in other words, what is the balance for the Trustees in the degree of risk they are prepared to live with and what the plan is for managing the scheme assets and the contributions.
Trustees do have some sophisticated tools at their disposal to monitor the scheme assets and liabilities, which allows them to prepare for de-risking. Trustees who have been proactive, gone through some scenario planning and therefore understand the decisions they would like to make and can wait for the right market conditions to execute those decisions are in the best position to act quickly because they are effectively further down the road.
Trustees have to consider whether they believe that interest rates will recover more quickly or slowly than the market expects. Although the Bank of England bank is committed to a base rate of 0.5% until unemployment falls to 7% – at the current rate of progress not expected before 2016, all it would take is a couple of political shocks in the Eurozone or Chinese debt spooking markets to seriously derail the global economic recovery. And this will inevitably mean that scheme funding levels will suffer.
On 22 September, Germany will hold a general election which could shake up the Eurozone’s most stable economy, while here at home the coalition looks set to see out their five year term to May 2015. The problem is that political decisions are much more likely to have a bigger impact than economic factors – neither seem exactly stable at the moment.
Now, as ever, trustees should be thinking about their strategies, how much risk they need to carry and if they can afford to hedge risk even if market conditions are not as helpful as they currently are. There are a number of actions which need to be in place before the ‘buy bonds now’ decision can be made, not least whether the scheme data underpinning the decision is both reliable and accurate.
As always, it’s all about the planning.