Preserving funding levels as rates fall

The following is an extract from our latest CIO update.

Funding levels have continued to increase over the past year, with liability values helped by relatively range-bound yields and rallying equity markets and credit spreads boosting asset values.

On average, most pension funds are well hedged. However, within that average, individual pension funds may still be actively considering their level of hedging.

For some it could be an incremental increase to hedging (say 5% or 10%), while others could be considering their hedging basis in light of their long-term goals and whether to strengthen the basis.

Other schemes could be contemplating the hedging of a surplus, while some may simply not have increased their hedging yet given their goals and strategy, or because it has not been their top priority.

For those considering the current environment for rates (and inflation), our Rates and Inflation team believes that there is room for UK yields to fall from here, even though there are risks in both directions.

Ultimately, therefore, for pension schemes with lower leverage, we think this could potentially still be an attractive entry point to increase hedging levels.

Value of insurance goes up, price goes up

While much of this CIO update has a US election theme, it’s worth acknowledging the recent period of political stability in the UK (for now). A diverse set of investor groups has bought ‘all the gilts’ to date, including a substantial increase from overseas investors. However, it’s also important to acknowledge that the UK is a small fish in a big pond. Directionally, global forces dominate.

Inflation, particularly in the US, has declined in such a way that investors are no longer scared of high inflation. Against this backdrop, we think there's room for yields to fall as investors fall back in love with the potential insurance that bonds can provide. In our active funds, we remain overweight, positioned for lower yields.

If bonds act as insurance for equity drawdowns, it stands to reason that they should trade with a premium. We can see this in the following chart.

Let’s contrast two periods in the chart:

• Period 1: During the low-inflation period of 2000-2020, bonds generally provided good insurance during periods of equity drawdowns. As investors recognised this insurance value, bonds became more expensive relative to equities. In other words, the yield on bonds remained significantly below the yield on equities (earnings/price)
• Period 2: As fear of high inflation picked up post-COVID, however, bonds provided poor insurance. In fact, bonds and equity market returns generally went up and down together. During this period, bonds cheapened relative to equities, or, put another way, the yield on bonds rose towards the yield on equities

As we look towards year-end, with lots of lower-inflation data in the bank, we think it's hard for investors to get concerned about high inflation. We therefore believe there's plenty of scope for bonds yields to fall relative to equity yields, and so we continue to tilt our active portfolios towards being prepared for lower yields.

The above is an extract from our latest CIO update.

 

Key risk

The value of an investment and any income taken from it is not guaranteed and can go down as well as up, and the investor may get back less than the original amount invested.