Investors currently buying UK government bonds are doing so in the knowledge that they are accepting a yield which is lower than the rate of inflation, i.e. the real yield is negative. Anton Eser, Chief Investment Officer at Legal & General Investment Management (LGIM) questions whether yields will remain at these low levels and what DB schemes looking to hedge should do.
The UK has not been alone in experiencing falling real yields over recent years. 30-year real yields have been falling in the US and euro zone at the same time. This suggests that there is something structural which has changed over that period.
Intuitively, there is a link between economic growth and yields. Over the long run, nominal GDP should be similar to nominal yields and, by just subtracting inflation, the same can be said for real yields and real GDP. In this respect, our view that global economic growth has been weighed down for a number of years by excess debt and deteriorating demographics is very important.
Efforts by policymakers to boost growth have been repeatedly derailed because the vast mountain of debt that has been accumulated is so sensitive to any rise in real yields. This can be defined as secular strangulation: policymakers are forced into more and more radical forms of monetary and fiscal policy, and this just creates even more debt, thereby pulling the noose even tighter.
Until there are significant structural reforms or – in some cases – debt restructuring, low real yields are a necessary condition for continued economic expansion.
Meanwhile, global demographics have deteriorated, with our economists predicting that the labour force is set to slow by around 1% per year. Furthermore, global productivity growth has declined, driven by an ageing capital stock (old machines not being replaced), the survival of ‘zombie’ companies (those needing a bailout/support in order to survive) and a lack of capital being directed towards fresh investment. In addition to these global headwinds, UK real yields are also being kept low by weak domestic growth.
What could make real yields rise?
There are good reasons for low UK real yields, and why they could remain low for some time to come. But taking the UK’s structural weakness to its limit, particularly if policymakers misdiagnose problems or miscalculate their response, there is a risk that real yields reverse direction, potentially in a dramatic fashion.
For example, if a UK government were to announce a big fiscal stimulus programme then it would probably boost hopes of higher growth and inflation in future years. This, combined with more gilt supply to pay for these initiatives, may initially put upward pressure on real yields. However, a move higher in real yields may not last for long as the structural downward forces could soon begin to dominate again.
But this could prompt questions over the sustainability of the UK’s deficits. By running a large trade deficit as well as a substantial government fiscal deficit, the UK relies on private sector investment as well as foreign capital flows to balance the books. Should the private sector’s confidence in the sustainability of UK growth fall, then the economy could regress into the type of deflationary spiral that has afflicted Japan for many years now. With nominal interest rates already very low, the Bank of England would struggle to react to such a scenario, and real yields could head higher.
The DB Dilemma
We think that DB schemes waiting to hedge their real rates exposure, hoping for economic growth to improve and for rates to normalise, will remain frustrated.
With the intense scrutiny on pension deficits unlikely to abate any time soon, we therefore think scheme sponsors will remain under pressure to inject cash in order to plug deficits, encouraging pension schemes to find the most efficient ways to hedge (e.g. with an increased focus on return-seeking strategies).
For those DB schemes who are already implementing an LDI approach, there is a strong argument for moving away from yield-based triggers towards time-based, or a combination of both. For instance, schemes may wish to use a strategy where they are increasing their hedge by a steady amount over a period of time, but there is the additional flexibility to accelerate hedging if there is a rise in yields.
For those clients who see a significant chance that real yields move higher, they may be considering whether it might be worthwhile for them to sell some existing holdings of inflation-linked gilts with a view to then buying them back at a cheaper level. But, unless they have a good hedging level to start with – given the material risk that yields stay low – we would argue against doing this. Instead, they may want to consider the implications for their growth assets.