How a bond bubble might sink Irish investors and pension savers

It has been described as "the biggest bond bubble ever" and it is on course to decimate investors around the world, if some market commentators are to be believed.

Last month Paul Singer, manager of the $28 billion Elliott Management fund, said investors are facing "the biggest bond bubble in world history". When prices start to drop, he warned, it will be "surprising, sudden, intense, and large".

But is it really a bubble – and what do investors and pension savers have to fear?

As Singer asserted, a scenario of negative yielding bonds “is in many ways the most peculiar period we have faced in 39 years”.

Interest rates and yields have never been this low or this negative, says Oliver Sinnott, manager of the Davy Global Bond Fund at Davy Asset Management. He notes that while financial repression in the 1940s and 1950s saw the yield of US 10-year treasuries drop to 2 per cent in 1941, the US 10-year rate is now 1.5 per cent. In contrast, German and Japan 10-year yields are both negative yielding. Irish short-term treasury bills are also negative.

Monetary policies

The driver behind these yields has, of course, been central bank monetary policies such as quantititaive easing, on top of inflation and low growth environments. Indeed across the world, government bonds are increasingly returning negative yields – about 51 per cent of oustanding euro sovereign debt is negative while almost 90 per cent of German bunds have negative yields, and 50 per cent of Irish sovereign debt is negative.

With yields so low, the price of bonds have risen sharply (the price of bonds has an inverse relationship with yields/interest rates, so as yields fall in line with interest rates, the price soars). But if and when rates rise again, the problem facing investors is that the price of bonds could fall sharply. For Sinnott, the swing in interest rates could hit holders of long-dated bonds sharpest.

“The longest dated bonds would suffer the largest volatility if yields rise,” says Sinnott, adding that long-dated bonds should come with a “risk warning”.

Andrew Milligan, head of global strategy at Standard Life Investments, agrees that a swing upwards in yields could be “serious” for investors.

A bubble – or not?

But warnings about a “bond bubble” may be a bit sensationalist.

“I think that unless the world is heading for recession and even more deflation, bonds are almost certainly overvalued at the moment,” Sinnott says. However, he urges investors to recognise the differences between an asset class like bonds, and more volatile assets like equities, which fell by more than 50 per cent when the dot com bubble burst and again during the last financial crisis.

“High quality government bonds are traditionally a less volatile than risk assets such as equities, and one of the main reasons for this is the influence of the authorities in this asset class,” he says, noting that central banks control shorter dated yields through interest rate policy, while forward guidance and QE excerpt a significant influence over longer-dated bonds.

“If there is a disorderly rise in yields, they are likely to try and suppress it because of its potential undesirable effects on economic growth (higher yields dampen growth) and other financial markets (a disorderly rise in yields is unlikely to be taken well by risk assets such as equities)”.

Milligan adds that if central banks were to allow a large rise in bond yields, it would be a “policy error”. Nonetheless, it won’t exactly be straightforward for monetary authorities to exit these policies while at the same time avoiding a sudden rise in yields.

“It is prudent to expect volatility and, if there is a large spike in yields, investors won’t want to be overexposed to very long-dated bonds,” advises Sinnott. “Play the long game – remember that the current low yield/low return environment will not last forever.”

The trouble for pensions

Falling bond yields also pose significant risk for pension funds; as interest rates fall, there is a knock-on effect and the value of liabilities increase.

As noted in the Financial Times recently, when interest rates were nearly 16 per cent, a pension fund wanting an annual payout of $16 million would need only to buy $100 million worth of bonds. But now with an interest rate of 1.5 per cent, a pension fund would only receive an annual payout of $1.5 million from a $100 million bond.

This is squeezing already beleauguered defined benefit (DB) pension funds. At the start of the year for example, figures from Mercer show that there was a deficit of just under €3 billion in the pension schemes such as CRH, Ryanair, Kerry Group, Paddy Power Betfair and Bank of Ireland. By the end of July, this had jumped by 97 per cent to €5.7 billion.

“If interest rates are lower – the returns will be lower and the value placed on the liabilities will be higher. Lower bond yields and lower investments returns = higher contributions are likely needed as part of the solution,” says Sean O’Donovan, head of DB risk with Mercer Ireland.

But higher contributions means less cash available for capital expenditure and dividends.

So what can they do?

“There isn’t one solution,” says O’Donovan, “it really depends on the level of funding the scheme had a few years ago, ie the impact of low bond yields will put some of these schemes in a difficult position”.

Using contingent assets to get them over this “lower for longer” period is another option, says O’Donovan.

The environment may also see more Irish DB pension funds look to close and switch members into DC schemes by offering an “enhanced transfer value” (ETV).

“These are very topical in the UK, and is now becoming very attractive in the Irish marketplace. A number of significant pension schemes have run an ETV, where uplifts to the standard transfer value has been made available to members,” says O’Donovan. However, he notes that it is important for members to get independent financial advice when considering this option.

Slowing the pace

In response, Irish pension funds are slowing the pace at which they build up allocations to low-yielding euro zone government bonds.

“They are considering global government bonds and corporate bonds as potential alternatives to eurozone government bonds (while yields stay low),” says Paul Kenny, a partner with Mercer Investments.

And it is not just DB members that face a risk. Pension savers who are coming close to retirement, and who have significant bond investments, may need to reconsider their asset allocations.

After all, if bond yields rise, their bond funds may have negative returns at a time when pension savers won’t want to lose any of their capital. This is particularly an issue if they have their eye on staying invested in an approved retirement fund.

“The risk is for members who are currently invested in a bond but don’t plan to take an annuity – there is a danger that the value of bonds will fall [if yields rise],” says Kenny.

If, on the other hand, they intend to take an annuity on retirement, this will be priced on interest rates so the impact will be closer to neutral

“Members need to take particular care as they get closer to retirement,” warns Kenny.

For now, the chance of a sharp rise in bond yields looks unlikely. And at least in the short-term, the outlook is unlikely to change.

“Obviously yields won’t stay this low forever,” says Sinnott, though he adds that it may be difficult to get a sustainable rise in yields until a number of factors happen. These include signs that central banks may be about to ease off or reverse their extraordinary monetary policies (particularly QE and NIRP); growth and inflation picks up from these anaemic levels; and governments on both sides of the Atlantic launch stimulus packages.

A world of negative returns: % of sovereign debt trading negative

Issuer: % trading negative

Switzerland : 100

Japan: 63

Germany: 67

Netherlands: 58

Belgium: 43

France: 48

Sweden: 44

Ireland: 50

US: 0

UK: 0

Australia: 0

Source: Standard Life