Bond yields are at all-time lows. This is not news – we have lived through a 30 year bull run in Gilts (10 year Gilt yields have fallen from 16% to 2% since the early 1980s). Congratulations to those individuals who matched pension fund liabilities with long dated bonds – and will have been protected from at least some fast inflating liabilities. Those that did not and are now going through, or have been through, difficult discussions with Sponsors need to be careful not to buy what they wish they already owned. Bonds are expensive, yields are low, inflation pressures are building and who knows what the longer term impact of global QE will be.
However, there is a good chance that some investors will look back at the current environment and ask why they held bonds at all or worse, why they increased bond exposure when most commentators think that there is a bubble. Most pension funds allocate 20% to 40% to bonds and, with a much shorter duration than the liabilities and a deficit to fill, those bonds provide little protection anyway.
If and when the bubble does burst, or slowly deflates, pension liability values should, in theory, start to fall – great for the valuation of fixed pensions. However, for pension funds with inflation linked liabilities, real yields are more important than nominal and rising inflation coupled with rising nominal yields may keep real yields low and liabilities high. So, what to do?
In our view the bubble is significant and consideration should be given to reducing duration exposure to side step the issue of rising yields. Additionally, adding inflation protection, either directly through a hedge or indirectly through growth assets, provides some protection from rising prices. Then when the bubble bursts those investors who took action can repurchase “matching” assets more cheaply in the future, rather than the passive investor who is left feeling deflated.