The Short View: The big squeeze on pension funds

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The gilt market will be closely watching UK chancellor Gordon Brown’s Budget statement. Will he do anything to relieve the pressure on pension funds, either by relaxing the regulations or by stepping up the pace of long-dated issuance?

The squeeze on the long end of the market saw real yields fall to less than 0.4 per cent earlier this year. The official data do not show much sign that pension funds have been piling into gilts. However, just keeping the gilt proportion constant was an effort last year when equities were so strong.

Many pension funds may be buying gilts through the indirect route. Figures from the Bank of England show that the notional value of inflation swaps increased from about £5bn a quarter in 2003 to almost £20bn in the last quarter of 2005. Swaps give pension funds protection against inflation but require banks (or other counterparties) to hedge their positions in the bond market.

Last week’s National Association of Pension Funds investment conference was dominated by discussion of “liability-driven investment”, through which fund managers attempt to outperform the growth rate of pension fund liabilities. Such portfolios usually require a core holding in the bond market or derivative instruments linked to it.

Although real yields have bounced back a little, they are still only 0.8 per cent on the 50-year index-linked issue. As George Cooper of JPMorgan points out, this compares with an earnings yield on the UK equity market (in effect, a real yield) of almost 8 per cent.

In the past, such a valuation gap might have provoked switching back into equities. But, given the regulatory climate, few pension funds will take that risk. The most they will do is hang on to existing equity positions in the hope that the stock market’s recovery will reduce their deficits.

The pension fund industry would like nothing better than for the UK government to slant issuance overwhelmingly to the long end of the yield curve. If yields rose as a consequence, deficits would fall further.

Mark Capleton of Royal Bank of Scotland suggests the government could over-fund its deficit to create supply. Has the chancellor been listening?

philip.coggan@ft.com

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