PensionsSep 25 2013

How US Treasuries and gilts affect annuity pricing

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But they are important to all other investors too. Most assets are sensitive to changes in gilt yields because their value, to a greater or lesser extent, is determined by the level of risk they represent compared to the ‘risk-free’ rate, which in the UK is the yield on a benchmark 10-year gilt.

When gilt yields rise, everything changes. In simple terms, corporate bonds are priced based on the amount of risk these bonds represent above the risk-free rate. Market analysts might consider, for instance, that the income you should receive from lending to BP for 10 years should be 2 per cent higher than what you would accept from the British government, and so the yield on a 10-year BP bond could be expected to be 2 per cent higher than that of a 10-year gilt. If gilt yields rise, the yield on BP bonds has to rise to maintain the ‘spread’ over gilts, and that means the price of BP bonds must fall because yield is inverse to price.

The king of markets

The price of equities is affected by gilt yields as well, although not in such a straightforward manner as for other bonds. If gilt yields are at 4 per cent, you would expect an equity to be performing considerably better through its dividends and capital gains to reward investors for taking a substantial degree of extra risk, say 8 per cent for a FTSE 250 company. But again, if yields rise you would need your equities to perform better to maintain that margin over the risk-free rate.

Other assets that are ‘bond-like’, such as real estate investment trusts (Reits) and high-yielding dividend equities, you would expect to be particularly sensitive to gilt yields – more so than for normal equities because their price is more to do with their dividend than expectations of future capital growth, and their dividend will be compared directly to the yield on a gilt. If gilts are paying a higher rate, Reits and other high-dividend equities will have to follow suit, and that can only happen by a fall in price.

So when gilt yields rise and the benchmark risk-free rate rises, most other asset prices automatically fall. The only dynamic that is likely to offset this is if the rise in gilt yields is due to an improving economic climate, which is deemed to be good for business and therefore good for equities, which may insulate equities from the rate rise.

Markets are heavily dependent on the risk-free rate. They operate sensibly when it is stable, but rapid changes can be chaotic. That is why gilt yields are king of the investment markets for UK pension investors.

Power behind the king

But if gilts are the king, then US Treasuries are without doubt the queen – the real power behind the throne. The yield on a 10-year US Treasury bond is the global risk-free rate that heavily influences the price of all other local benchmark government bond yields around the world, the relationship to gilts shown in Chart 1.

The story for investors this year has been all about the risk-free rate. The global risk-free rate had been slowly rising all year as expectations of further bouts of quantitative easing (which have been keeping yields artificially low) across the Atlantic dwindled.

But on 22 May, Federal Reserve chairman Ben Bernanke opened the floodgates when he spelled out a timetable of how and when QE would slow down and when interest rates might rise. Treasury yields rose immediately, as did gilt yields and all other government bond yields, triggering a sell-off in all assets as they repriced to take account of the soaring risk-free rate.

Without any real underlying economic or business improvement, equities were just as vulnerable to the revaluation as bonds. Since then, the risk-free rate has been rising steadily, picking up pace through August and September, hitting a milestone when the 10-year gilt breached 3 per cent on 4 September – the first time it had done so since 2011.

Unstable markets

Over the summer all assets had been highly volatile as the market lurched back and forward, trying to get a feel for how quickly interest rates might rise, with the risk-free rate steadily creeping up ahead of this timetable. The market has been hopelessly inconsistent, lurching from side to side like a sailor desperately trying to catch the wind without being able to tell which direction it is coming from. One day equities sell off due to better economic data because that is seen as a signal that QE might be ‘tapered’ or withdrawn more quickly. On another day the same sort of news has the opposite effect as equities are boosted by evidence of a brighter economic outlook. With too much speculation and not enough hard facts, the markets have been totally disorientated.

Investors have been understandably alarmed. Cautious investors heavily exposed to bonds, particularly longer-dated bonds which are more sensitive to future interest rate changes, have been hurt by capital losses. Equities have had a good year overall, but only if you invested in the right sort of equities (namely ‘value’ stocks least sensitive to gilt yields).

Those in drawdown who expect to review their income imminently may be in for a pleasant surprise as long as they haven’t lost a good chunk of their portfolio on the bond markets. For anyone looking to buy an annuity, however, it is good news with income levels steadily rising to new recent highs – again, as long their investments have not been tracking gilt prices too closely.

For clients still some way off retirement who may have taken a relatively cautious approach, now might be the time to reconsider that strategy, if they have not already done so. Low-risk assets that are at serious risk of capital loss are not low-risk in any meaningful sense, and that is the position that gilts have been in all year.

Counterintuitive though it may be, when you consider the risk of capital loss, ‘shortfall risk’ (the risk of your client undershooting their investment target) and the prospect of future inflation, bonds are not the place to be right now and may not be for some years to come.

Many commentators have already called the end of the long bull market for bonds. IFAs should urgently revisit this matter with any client whose ‘low-risk’ portfolio could be set up only for disappointment at the hands of a ruthless king and queen of capital markets.