“Both bond and equity markets were fast out of the blocks at the start of this year - and their price swings helped the PPF 7800 index aggregate funding level bounce higher to 96.9% from 93.9% at the end of December. The funding level improvement would have been much greater had the upward trajectory of equity markets not given way to a severe bout of volatility at month end. In the end, the loss incurred to pension scheme asset values from falling equity markets was more than offset by a fall in liability values due to rising gilt yields, so the net result was for pension scheme funding levels to improve. Recent equity market moves beg the question - is this the reawakening of market volatility or just a short-lived aberration? Time will tell, though it is unusual to experience a sustained period of high volatility against a steady and strong economic backdrop, like the one today.
“UK pension schemes that have de-risked in recent years are now less susceptible to equity market volatility; on aggregate, PPF 7800 schemes now have a 10% lower portfolio allocation to equities than they did five years ago. Meanwhile allocations to bonds and private markets have risen. Holding cashflow generative assets, such as government bonds, credit and private market debt, can help protect pension schemes during an equity shock like the one experienced in January. We find that for cashflow negative schemes with funding gaps to close, equity shocks can be very problematic if the scheme is relying on disinvestment to fund cash outflows. The reason is that following a shock the schemes equity assets are diminished; subsequently disinvesting to fund cash outflows means equity assets are diminished even further. Essentially, the scheme is foregoing future equity returns and the impact of this compounds over time and can be a significant drag on funding levels. On the other hand, holding cashflow generative assets to fund cash outflows can alleviate the problem by removing the need to sell equities, or other assets, and allowing the asset values to grow over time. This is one demonstration of how pension schemes must consider risk, return and cashflow in their portfolio to successfully meet their objectives.
“So far in 2018 government bond yields have marched higher, driven by a stronger outlook for global growth and inflation, and in turn an expectation of tighter monetary policy. Although the US has been the main driving force, the UK is also joining in the party. Last week the Bank of England caught the market’s attention; in the Quarterly Inflation Report the Bank revised upwards it’s growth and inflation outlook and indicated that it may be appropriate to raise policy rates ‘earlier and to a somewhat greater extent’ than they previously thought. Whilst exciting for short-term investors, we think the longer-term context is important here; the Bank still only expects to raise policy rates around 75bps over the next three years, reaching a level far below previous norms. This is in keeping with our expectations for bond yields over coming years - we expect nominal yields to rise due to global inflation slowly heating up and economic slack diminishing, but the upside to yields is very much limited by structural forces; demographics, slow productivity growth, pension fund demand, and more broadly, a build-up of global savings that are seeking safe, liquid assets.
“With this in mind, we encourage pension schemes to view recent movements in bond yields as an opportunity to implement hedging rather than a reason to delay. In fact, for those looking at reducing funding level risk, market conditions today look particularly favourable; linker dealing spreads are tight, repo can be accessed readily and cost effectively, meanwhile 10-year swap rates are back to pre-Brexit levels. Whether or not volatility persists in global markets, these are attractive opportunities for UK pension schemes.”
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