Pension funds marred by gilt bubble

Pension funds marred by gilt bubble

	Published : Thu, 19 Jan 2006 09:15 By : James Rowe Print this Story

LONDON: The gilt market in the City is in virtual panic as yields fell to its lowest in nearly half a century -- the benchmark 50-year index-linked bond collapsed from 0.59 per cent to 0.48 per cent Tuesday and again hitting a low of 0.41 per cent Wednesday before getting back to its starting point -- and pension fund managers are scurrying for cover.

Trading in the 50-year bonds came to a standstill Wednesday when pension funds went on a buying spree to keep their portfolios in shape as the world's financial markets faced a crisis with the Tokyo Stock Exchange prematurely closing for the day. Fund managers said the extremely low yield levels in bonds can raise the pension fund deficits by more than half this year.

The Tokyo exchange debacle forced fund managers to look for safe alternatives and government bonds came in handy. Bond dealers said there is extreme lack of supply in the 50-yer bonds, which the pension funds rely for long-term pension liabilities. This had pushed the prices up, which in turn affected the yield levels. A low yield means funds will get reduced returns on investments.

The government has been urged to release debts into the gilts market to stem the crisis. It has not taken a similar action in the past several years and there is a regular gilt auction scheduled for next week.

A spokesperson for Debt Management Office, the executive unit of the Treasury, said the government is aware of the situation and it is monitoring it. It has legal powers to issue extra government debt in "exceptional circumstances".

Investment analysts describe the situation as bad news especially for the pension funds. Pension funds are mandatorily required to park much of their funds in gilts, but falling returns reduce the value of the holdings and leave them with larger deficits. Economists explain falling yields of long-terms bonds as a warning sign for an impending recession. However, they say the current crisis could be as a result of the Tokyo exchange imbroglio and may not have a major impact.

The Bank of England had earlier this week talked about low yields on bonds with both governor Mervyn King and his outgoing deputy Sir Andrew Large pointing at strong rises in asset prices in the recent months. Price of 50-year gilts had shown a 17 per cent increase in December. In the gilt market, the price moves inversely to the yield. King had said it will be dangerous if policymakers took real lower interest rates for granted. Sir Andrew warned of a "non-zero risk" of a crash on the financial markets.

Actuaries expect to have a critical time calculating the value of the pension funds and evolving strategies to contain liabilities. The liabilities are calculated using a discount rate based on bond yields. As yields fall, liabilities increase. This leads to a vicious cycle in which pension funds buy index-linked gilts to match liabilities, forcing real yields to lower and causing the funds to buy more gilts.

The problem with the long-dated gilts is that they are released in small quantities. The total 50-year index-linked issue is worth just 2 billion pounds.

Some fund managers said the sudden fall in real yields could be related to the introduction of a risk-based levy by the Pension Protection Fund. The levy will be partly based on the size of the pension fund’s deficit.