Ultra-low UK yields '˜medicine' brings challenges but drives up returns

12 August 2016

It has now been more than a week since the Bank of England (BoE), the UK's central bank, halved interest rates to 0.25% and enlarged its QE program by £70bn, in order to stem any further economic decline coming from the Brexit uncertainty. In spite of this markets and commentators seem to only slowly be getting their heads around potential effects and consequences. There was much debate this past week over the consequences of near 0% UK gilt yields for maturities of up to 10 years - in terms of economic outlook, but also for savers, company pension funds and commercial bank's medium term ability to remain profitable.

To say it upfront, the side effects are nothing the BoE would not have taken into account and couldn't be overcome with a little bit of '˜thinking outside the box'. Savers probably feel hardest done by the further cut, although a drop of 0.25% hardly constitutes a big change to what they had before. One important consolation for savers is that consumer price inflation in the UK is currently also less than 1% and therefore at least cash is actually eroded less by inflation than usual, which means that cash fulfills its role as a store of purchasing power - at least over the shorter term.

Banks make less and less money from their customers' deposits the closer we get to the 0% line, because their interest margin is eroded. Here is why: Say they offered deposit rates of 2% when the actual bank rate was 3%, this resulted in an interest margin of at least 1%, whereas now they can only get a meagre 0.25%, because they shy away from charging clients for holding their money on deposit. While this makes it tough for banks to earn a margin in this specific segment, they have other areas in which they still earn good money, be that personal loans and credit cards, corporate lending, mortgages or investment banking and wealth management services. As the strong recent results of the US banking sector have shown, banks can still earn a good living in a low interest environment.

Pension funds backing defined benefit schemes appear - at first sight - to be a bigger problem. Their future payment obligations to their pensioners are translated into present day values by discounting them down by the yield payable on government bonds with the same maturity as the future payment obligation. If a pension fund meets future liabilities solely by investing into maturity matching government bonds, then there is no shortfall risk potential - the pension provisions are deemed sufficient and the company is in everybody's good books.

The trouble is that the lower the government bond yield, the lower the discount factor and therefore the closer the current, discounted liability to the actual future liability. By way of example, if 10 year yields are at 5%, then the company needs to fund the pension fund for pensions due in 10 years with 61% of what they will have to pay, whereas if yields are only 0.5% (as they are currently), then the funding requirement rises to 95%. This is what is behind the headline grabbing increase in pension deficit numbers.

However, it is clearly within the power of the pension regulator and the government to break this unhelpful relationship. As our own investors have experienced, long term returns from prudent investment across all asset classes and around the world can - and most usually will - generate much better returns than the just 0.5% currently available from 10 year UK gilts.

By forcing pension funds to hold government bonds to hedge their liabilities or face crippling charges from the pension protection fund, if they invest into more viable mix of assets, the pension deficits are, to a large extent, of our own making. If the government decided to allow pension trustees to apply discount factors which are more in line with actual long term return experience and stop penalising funds to invest for growth, then not only would much of the current pension deficit go away, but also much needed risk capital would push into the economy and stimulate growth. Alas, the cynical side in me suspects that the government values the ability to force pension funds to buy their debt issues quite highly, as it means they don't have to fend off pesky bond vigilantes, who might question government's spending plan (More detail about the pension impact/dilemma in the next article)

Most relevant for our investors is probably what low interest rates and yields have indicated in the past. That is, expectations of very low rates of return across all asset classes in the future, which would make them content to be locked into very low returns from interest for years to come.  Furthermore, no improvement in economic growth which may cause inflation - from which bond holders would want to be protected by way of higher interest payments.  At the moment, however, rising equity markets suggest that stock market investors are looking far more optimistically into the future and are willing to assume that corporate earnings (driving dividends/growth) will improve in the near future.

Worryingly, bond markets have in the past got it right more often than the flightier and sentiment driven stock markets. So are equity investors in for a bad awakening?

Not on the basis of the low yield indicator. This time around bond markets are literally '˜rigged'. Or at least distorted by the central banks' extraordinary monetary easing programs through quantitative easing (QE). Bond yields have temporarily lost their previous indicator ability after the UK's, the Eurozone's and Japan's central banks pledged to buy ever more bonds in order to stimulate their economies out of the slow growth malaise through very low cost of finance/capital. As long as bond investors buy low yielding bonds because they can reasonably expect that the central bank will always bid the price for their bonds higher in the future, then their demand for low yielding bonds cannot be interpreted in the traditional '˜low-growth-expectation' way.

This obviously makes bond prices very dependent on central banks, but for the time being they cannot and will not stop their QE purchasing programs without giving ample notice. For the near term this has created a very supportive environment for stock markets, because, except for the UK, most economies around the world are showing signs of resilient growth, with much potential to accelerate from low growth rates as jobs and wage growth stimulates demand, capital remains cheap and cash holders are tempted back into more productive forms of investment or risk losing out.

The highly overvalued bond markets obviously need to be watched closely for signs of retreating central bank support, but until this happens, the current goldilocks dynamic generates very healthy returns for portfolio investors. For the portfolios we look after, these now stand mostly around the double digit threshold for 2016 - levels very few would have expected during the turmoil of the beginning of the year or after the Brexit outcome of the referendum.