Under quantitative easing (QE) the Bank of England has been pumping in more than £200bn in the system, buying gilts and corporate bonds, but now it has pulled the plug, concerns have been voiced that it could upset the gilt market in the months ahead.
The effect of QE has been to keep gilt yields at low levels, some would say artificially low, because until now investors have been confident in buying gilts knowing that the Bank of England will buy them should they wish to sell.
The question is, if the Bank of England turns off the QE tap, as it has said it is doing for the time being, who else will buy UK gilts? If the buyers stay away, prices will fall and yields will rise with potential ramifications for pension funds.
Last month, Bill Gross, co-founder and co-chief investment officer of Pacific Investment Management Co. (Pimco), the world’s biggest bond fund, warned investors to stay away. He told them that UK government bonds are “a must to avoid” and that gilts are “resting on a bed of nitro-glycerine”.
But many have dismissed Gross’ comments as scaremongering. Helen Dowsey, an actuarial consultant at Aon Consulting, says: “When QE ceases completely it could change the supply and demand dynamic and result in market disruption. Most commentators believe the market will be unable to absorb the expected levels of gilt issuance over the coming years without lower prices, which is the same as higher yields.
“Potential changes to regulations requiring banks to hold more gilts on their balance sheet could to an extent offset the cessation of QE.
However, a credible fiscal plan will be needed to appease financial markets and potentially avoid gilt yields moving sharply upwards. Another key issue is how and when the gilts held by the Bank of England will be sold back – this could cause further market disruption.”
Many UK fund managers admit that the gilt market is in for a bout of volatility but they also question the severity of the Pimco warning.
Richard Woolnough, who runs M&G’s corporate bond funds, said the advice that gilts should be avoided was an “exaggeration”, although he admits it has “some punch in the short term”.
He adds: “I agree with the direction of the consensus; absorbing that much new supply will be negative for gilts in the short term. However, in the longer term Britain has the chance to adjust to the crisis through fiscal stimulus, financial reform and a falling exchange rate that might well provide the medicine required.”
Ian Spreadbury, bond manager at Fidelity, also admits that he is not that keen on the value of government bonds relative to corporate bonds at this juncture. He is currently running high yield at around 27 per cent and investment grade corporate exposure is around 64 per cent in his portfolios.
A key issue for asset allocators in 2010 will be whether the Bank of England restarts QE, probably on concerns that the economy is too weak and inflation cannot meet its target
He says: “But while we may initially see some indigestion in the gilt market following the decision to pause quantitative easing, there is still enough capacity in the private sector for future government bond issues.
“I am not overly pessimistic on the outlook for gilts as, on top of normal buying activity, there is a lot of cash sitting on the sidelines, particularly in Asia, that could find a home in government bonds. In addition, banks are likely to be big buyers of gilts going forward as a result of higher liquidity requirements.”
The defined contribution team at Schroders believes that whether gilts underperform to such an extent or not, it has changed the emphasis placed on the asset class in pension funds.
It believes that the financial crisis and QE have made fixed interest a more volatile asset class than it has been in the past and that this could have a knock-on effect. It says that it could impact on DC fund design and what members understand by risk.
“You might have to change the definition of risk because balanced managed funds or those with a simple equity bond split will see more volatility than they would expect,” says Mark Humphreys, head of strategic solutions at Schroders. “Our view is that we will see a movement in yields and there will be more volatility than in the past and this could raise a communication issue with members.”
Humphreys reckons that the uncertainty in the gilt market could highlight the limitations of lifestyling – a strategy he admits he is not too keen on – and place more emphasis on target date and liability driven style strategies.
Critics of lifestyling say it can be too inflexible and too mechanistic a process. Humphreys reckons you can reduce the risk of a fund further away from retirement than lifestyling allows, without being exposed to direct asset risk using swap instruments, or losing out on return potential.
He says: “With lifestyling, if you switched out of equities early you would get a return drag on as the earlier you switch out the more you lose out on the outperformance of equities. Now the switch is made later and I feel that this means that the annuity risk is being addressed too late.”
Humphreys suggests that liability-driven investing – so far the domain of defined benefit schemes – could have a role to play in the DC arena. “It is being closely looked at but no one is using swap instruments. We think it is possible,” he adds.
Other actuaries remain sanguine about a wholesale shift out of gilts (or corporate bonds for that matter). The problem of timing the market is a perennial one for trustees, DC or GPP members. Bonds are affected by rising interest rates and inflation and although there have been signs that both will rise, even the Bank of England Governor has indicated that his committee are none the wiser on whether it will be a problem. The latest meeting of the MPC suggested that inflation would spike before coming back down, while the consensus is now that interest rates will stay at very low levels until 2011 at the earliest.
Peter Black at Lane Clark & Peacock is wary of a wholesale shift into bonds – he suggests that the end of QE could have a double whammy affect, disturbing both the bond and equity markets if the withdrawal of money supply leads to a double-dip recession.
It is why he believes that wholesale asset allocation changes should be kept to a minimum. He says: “Many trustees have been concerned and may try to reduce risk in their portfolios and switch to bonds, but that might not be the right strategy at this time because of the volatility in the bond market.”
Some experts reckon that the issue for asset allocators is not the end of QE – it is whether it resumes later in the year. Andrew Milligan, head of global strategy at Standard Life Investments says: “In some respects it is difficult to show that QE has had much impact – after all UK money supply growth is close to zero. Secondly, markets are forward-looking, so some months ago they priced in the end of QE – one reason bond yields have risen. A key issue for asset allocators in 2010 will be whether the Bank of England restarts QE, probably on concerns that the economy is too weak and inflation cannot meet its target.”
Dowsey: ’”A credible fiscal plan will be needed to appease financial markets”