11 Oct Investment Markets Update – October 2022
11th October 2022
Bonds Markets Update
We have had a number of calls from clients in the last fortnight, worried about media reports of their “pension schemes” going bust. We have also seen financial markets stories making the lead story on news bulletins and the front pages of newspapers – a sure sign that something is amiss.
So, the purpose of this article is to try to set out what is going on in the Bond Markets at the moment, and how that might affect your pensions and investments.
What is a Government Bond?
Firstly, a reminder that a Government Bond is simply a loan from investors (individuals, Unit Trust / OEIC investments or pension funds for instance) to the Government. The loan is set at a fixed rate of interest and usually has a fixed term e.g., five years, 10 years or even 30 or 40 years in the future. At the end of the term, the Government must repay the loan capital, having paid the interest in the interim. Government Bonds are often referred to as “Gilts” and, in terms of loans to the UK Government, are regarded as very low risk. The British Government has never defaulted on its Bonds (although Charles II did, effectively, default in 1672, before the Act of Union with Scotland created the current British State).
So what’s happened?
A year ago, UK Government Bonds (depending on their maturity date) were typically paying an interest rate of approximately 1.5% and this low rate of interest has helped the Government keep its borrowing costs from the £400 billion Covid bill (and all its accrued previous debts) to a manageable level. However, as interest rates around the developed world have increased this year, Government Gilt yields also ticked up slightly. However, the Fiscal Event/Mini-Budget (delete as according to your political preferences) has brought an entirely new dynamic to the Government Gilt market. There appears to be a “black hole” of around £62 billion between what the Government has to spend in the year ahead and what it is planning to take in taxes and borrowing. The Government has not yet explained how that gap is to be filled and in the meantime the Bond markets have been selling Government Gilts very sharply, given this unclear outlook.
Who is affected by this?
This sudden selling of Gilts has many knock-on effects, and one of them has been on Defined Benefit pension schemes (often called “Final Salary” schemes). Those schemes hold considerable sums of money, which will be needed to pay pensioners of the future, when they reach retirement age. In the meantime, the Trustees of those pension schemes are required to ensure that the assets of the scheme will be sufficient to match the liabilities, both existing and those of future pensioners. The investment strategies employed by those Trustees includes Government Bonds. For two decades or more, Defined Benefits schemes have used “Liability-driven investment” (LDI) strategies, to hedge their liabilities with Government Bonds. The rapid fall in Gilt prices following the recent Government tax announcements – which therefore means the Yield (or interest rate) goes up accordingly – meant that Defined Benefit pension schemes found they had to sell those Gilts to create cash needed to cover their potential liabilities of the future. This forced-selling created a “doom-loop” as Gilt prices fell further and therefore required pension funds to sell down yet more Gilts, driving the prices down yet further….and so on.
Defined Benefit – v – Personal Pensions
The media picked up on this crisis within Defined Benefits pension schemes and it was widely reported that many of them had been in danger of “going bust” – i.e. unable to match their future liabilities against their current assets and with the sponsoring Employer not being in a position to inject further funds. Whilst this was true, it had no direct impact on holders of Personal Pension/SIPP funds. Unfortunately, the media – chasing for cheap headlines as ever – almost completely failed to differentiate between Personal Pension pots and Defined Benefits pension schemes. The word “Pension” was reported in a general sense and effectively conflated the two types of scheme in the minds of many readers.
Although Personal Pension funds have certainly suffered during 2022, for reasons discussed in others of our newsletters and widely reported in the Press, they are valued on a daily basis and the assets (mostly equities and bonds) remain in place each and every day, even if the price changes. Unlike Defined Benefit schemes, the modern Personal Pension carries no guarantees and – counter-intuitively – this can be beneficial in times of financial stress. Where guarantees have to be met, and there are insufficient assets in place at a particular point, the entire Scheme can collapse, as those readers with Equitable Life policies will remember from 20 years or so ago.
Bank of England intervention
The Bank of England was alerted to this crisis within Defined Benefit pension schemes a week or two ago. It took immediate action. It started buying up some of the Government Gilts that were being sold on the market, thus stabilising the price of those Gilts. It also announced a Programme to continue buying such Bonds up until Friday 14 October. The immediate effect of this was relatively successful and Gilt Yields steadied.
However, the matter has not yet ended. Initially, the Bank bought less Government Bonds than it had suggested it might and for a few days it looked as though they might get away with spending rather less on buying Bonds than initially thought. However, the markets began to test this by selling further Gilts and sending prices lower and Yields higher again.
Yesterday, the Bank of England also announced it would include index-linked Bonds amongst those it would buy from the market, thus widening its support for UK Gilts in general. It’s clearly keen to show it means business and will intervene to shore up the Government Bond market during this turbulent time.
Is this a crisis?
I would suggest that it is. Suddenly, the man on the street is becoming aware that Government Gilt Yields are reaching around 4.75% on 10-year Bonds. When this sort of esoteric information makes the mainstream media, you know there is something amiss. Indeed, it rather reminds me of the days in 2008 when the media were reporting daily on the price of Greek Government Bonds (which reached over 10% at one point) as the markets were testing the European Central Bank to see if it would save Greece from falling out of the Euro currency.
Back then, all it ended up needing was words of reassurance from the ECB President, Mario Draghi that the European Central Bank would “do whatever it takes” for the markets to be reassured and settle down. I am not convinced that such words from the current Bank of England Governor, Andrew Bailey, would have quite the same reassuring effect. My suspicion is that the Bank of England may have to continue buying Government Gilts for longer than they had first anticipated.
As I have explained, the Bank of England has been dragged, unwillingly, into effectively bailing out the Gilt market resulting from a widely criticised Government tax statement. Indeed, we are effectively seeing a push-me-pull-me tussle between the Bank of England and the Government, one of which wishes to maintain stability in the financial markets and the other wishes to push for unconstrained economic growth. The markets are aware of this conflict and are testing the resolve of both parties. Needless to say, hedge funds are amongst the action and can sometimes actually move the market themselves by betting against the price of Gilts etc., adding to market difficulties.
Could Defined Pensions schemes go bust?
Well, although unlikely, it could be possible in the sense that if the price of Gilts kept on falling and the current LDI strategies that many of these schemes operate with effectively fails, than we could have a situation whereby many private company Defined Benefit pension schemes become technically insolvent. There are many thousands of such schemes that have been in that position for years, of course, and they are now under the jurisdiction of the Pension Protection Fund. The PPF provides security of up to 90% of Defined Benefits schemes members pensions, depending on certain criteria. It is funded by a levy on all of the remaining active Defined Benefit pension schemes. In a doomsday scenario, if a significant number of Defined Benefit pension schemes were to fall into an insolvent position and have to refer themselves to the PPS, then there would be insufficient active pension schemes still paying the levy to cover the liabilities of those within the PPF. At that point, it becomes very difficult to know what would happen next, other than to say that Defined Benefit Pension scheme members would be facing a significant haircut on their own pension benefits.
In all honesty, I find it hard to imagine how any Government could politically allow that to happen and so I come back to thinking that the Bank of England (albeit which is independent of the Government) would likely intervene in whatever level is needed to ensure the continued stability of the UK’s financial position and that of Defined Benefit pension schemes. Or alternatively, the Government would become involved to ensure there wasn’t complete decimation of Final Salary benefits to millions of people.
What next?
For now, I expect to see further testing by the markets on Government Gilts and to test the determination of the Bank of England to maintain the price of the Government Bonds. The hope will be that the Bank of England’s interventions will be deemed sufficient, and the pressure will ultimately be taken off Government Bonds. The Government itself has brought forward its Statement with regards to tax and borrowing from 23 November to the end of October in an effort to calm the markets as soon as possible. The good news is that earlier today, there was a successful auction of 30 year index-linked bonds, which was 2.75x oversubscribed. The Yield (i.e. the governments’ interest payment) was a pretty hefty 1.5% + RPI inflation (Index-linked Bonds still link to RPI), but the over-subscription suggests a healthy appetite amongst investors for these types of Bonds, despite the current uncertainties.
In the meantime, for those readers with Personal Pensions, you will see any investments held in Government Bonds being very volatile indeed and this is likely to continue for some time. This volatility may well feed through to a lesser extent to Corporate Bond holdings and even UK Equity investments. However, the assets remain in place. The shares remain in existence. The Bonds are still under contract. The UK Government has still never defaulted on its Bond borrowings and I am extremely confident will not do so now and so, although concerning, there is no need for panic amongst personal pension policyholders. Those pension funds will move around in value – sometimes down – but they cannot go “bust” in the way the media has scared some people.
Please note these are the views of Christopher Charles Financial Services Ltd, and are for background information only. They do not constitute advice, nor should action be taken without specific advice, pertaining to individual circumstances. Investments can fall as well as rise in value, and you may not get back as much as you invested, particularly in the short term. E & O E – figures are produced with great care, but no liability whatsoever can be accepted for any errors of information within this document. Past performance is not a guide to the future. Christopher Charles Financial Services Ltd is authorised and regulated by the Financial Conduct Authority.
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