13 May 2024 2 min read

LDI chart update: Value is in the eye of the bondholder

By Robert Pace

Although headline real yields trade around 1.5%, average forward real yields post-RPI reform (after 2030) are just under 2%, which is well above historical long-term cash returns of 0.9%.

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Rather than consider potential price appreciation for linkers, in this chart update we consider how current real yields compare to historic real cash returns over long time periods. In the interests of brevity we also avoid discussing r* or the natural rate of interest.

This consideration is relevant for the leveraged LDI investor as a hedging trade can broadly equate to an agreement to pay cash returns and receive long-term real yields. If long-term real yields are sufficiently high versus future expectations for real cash returns then there is an argument to hedge and lock those terms in, purely on return grounds.

There is lots of historical data to draw on here, thanks to the Bank of England’s excellent 300-year data set. The annual Barclays equity gilt study is also a helpful source.

Today, we look at data from 1900 to the present day. Over this period, the average real cash return has been 0.9%[1] (relative to CPI). As the chart above shows there have been long periods where real cash returns have departed from this average. World wars stand out, as do the 1970s and 80s.

Historically, periods of high inflation and low real returns have generally been followed by high real returns as the market reverts. 

What does this mean going forward?

The real yield forward curve broadly represents the market-implied evolution of real cash rates. If you believe real cash rates will evolve at a lower value than this, then the linker has the potential to be good value.

The graph shows that historically real cash rates have been mean reverting towards the long-term average of 0.9%, which makes sense intuitively given they should be range bound (albeit the cycles involved can be long!).

It has been said that good investing rarely feels comfortable and reasons can certainly be found not to invest e.g. what if it’s higher for longer and longer? Who will buy all those bonds? etc. Nonetheless, current real yields on offer of 2% compare favourably to historic cash returns, and we see potential value at these levels for LDI investors.

 

Assumptions, opinions and estimates are provided for illustrative purposes only. There is no guarantee that any forecasts made will come to pass.

[1] 1 May 2024 market conditions. 10-year forward real yields averaged between 2030 and 2044. After 2030 RPI reforms to CPIH which offers a better comparison to real cash returns versus CPI.

Robert Pace

Senior Solutions Strategist

Robert works with clients on LDI and broader solutions-based investment strategy. His three Rs are rates, regulation and arithmetic (showing a maths degree lives on forever). When Robert is not pondering LDI or investment strategy and talking to clients, he can often be found cycling in the Surrey Hills or watching hours of cycling coverage on Eurosport (at 30x speed in order to prolong his marriage).

Robert Pace