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Bubble and squeak

Pension schemes and insurers are piling into gilts but will it all end in tears?

If you listen to the soothsayers, there is a profound and potentially dangerous development going on in the financial world right now which could hurt us all. There is a bubble.

Investors are pushing up prices for reasons that have little to do with economic fundamentals. There is a lack of supply and seemingly insatiable demand. They are investing for safety but their investments are almost certain to return hardly anything. There is a risk that the bubble could burst, leaving many facing a huge capital loss.

I am not talking about house prices. This is a bubble in gilts and the luminaries warning about its dangers include Bank of England governor Mervyn King, top financial commentators such as John Plender and Hamish McRae and distinguished financial gurus like Willem Buiter from the London School of Economics.

Pension funds and life companies are moving out of shares and piling into long-term gilts on a scale not seen in years. That cuts the returns you can hope for from your life policy or pension.

The reason they are doing it is understandable on one level. Many companies are approaching their year end, when they have to declare their pension liabilities on the FRS17 accounting standard. Most finance directors are staring at a yawning gap between their liabilities and the assets they are going to need to finance them.

Many are adopting the Boots approach: get rid of the problem by matching your assets to your liabilities. If you have gilts instead of shares, you know what income you will get to pay those pensions. The only risk is that the Government might default. Highly unlikely.

The FSA thinks so, too. Pension schemes which have done this will pay a lower premium to the Pension Protection Fund because the company is less likely to claim. If life companies buy security in the shape of gilts, they are looked on as having boosted their financial strength.

But by offloading risk, pension schemes and life insurers are reducing the rewards they can expect and paying a massive price for that security. The best measure of the price being paid for gilts is the yield (for the layman, the interest you get relative to the price you have paid). That moves in the opposite direction to the price. The more you pay for a gilt, the less it yields. That yield is hitting extraordinary lows. Last week, the real yield on 50-year index-linked gilts was 0.38 per cent. Pension schemes and insurance companies are paying high prices for an investment that will return hardly anything.

A vicious circle is operating. When pension funds and life insurers pile into gilts, demand exceeds supply. The price goes up and the yield goes down. But here is the vicious bit. Actuaries evaluate pension liabilities using the yield on long-dated gilts. The lower the yield, the higher the liabilities. As yields have shrunk, liabilities have grown, making the gap between assets and liabilities even more alarming. Investment directors buy more gilts to improve the position and the circle takes another turn.

The Government could break one of the links in that chain – lack of supply. Why not simply issue more long-dated gilts? The Debt Management Office has done so, issuing 650m in long-dated gilts. But according to Willem Buiter in a letter to the Financial Times: “This is the equivalent of going on a tiger hunt armed with nothing but a smile and a peashooter.”

Pension funds and life insurers complain that the regulatory environment forces them to buy security at all costs. Actually, there is nothing in the regulations which requires pension schemes to put more of their money in gilts. But even if the regime does not require it, it clearly encourages it. The risk-based premium for the Pension Protection Fund has a nasty side-effect. To reduce that premium in the short term, the pension fund may buy gilts, arguably acting against the interests of the scheme in the long term. The experience of Standard Life alone is enough to demonstrate that if a life insurer retains risk in its investment portfolio when others are offloading it, it may get badly burned.

Are Government and regulators, however inadvertently, making this bubble worse?

Money Marketing50 Poland Street, London W1F 7AX


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