“October was a tumultuous month for UK markets; Brexit related political and economic uncertainty caused Sterling and government bond prices to plunge (and therefore yields to rise) and inflation expectations to jump higher. However, amid the turmoil, UK pension funds found some reprieve. Higher yields caused liabilities to fall more than assets, resulting in a net increase in funding levels. The PPF 7800’s aggregate funding ratio rose from 77.5% to 81.4% during October, adding to last month’s improvement. Whilst this is a welcome gain, in reality it equates to a few small steps in a gruelling marathon journey to close pension deficits. Despite the recent rise, the level of aggregate funding has only been lower on a handful of occasions over the past decade.
“Liability hedging deniers – who may have been waiting for a moment such as October’s huge 40bp increase in long-dated government bond yields as evidence that what goes down must come back up – may be puzzled that funding levels didn’t improve further. The answer lies in the nature of the yield rises. Pension funds care most about real yields, not nominal yields, given they pay inflation-linked pension increases. Because the majority of the rise in nominal yields was as a result of higher inflation expectations following Sterling’s fall, real yields had a much lesser move. This reinforces our view that the potential reward from under-hedging interest rate and inflation risk is less than it has been in the past – under-hedging is not the silver bullet to solving the pension fund problem.
“Our long-standing view is that that yields will be structurally low for the foreseeable future. The powerful forces behind our low rates view are still in place; tepid global growth, Brexit headwinds hindering the domestic UK economy and, importantly, an insatiable demand for government bonds from both private investors and central banks. We continue to recommend that most pension funds hedge more interest rate and inflation than their current levels. Those funds with higher inflation hedge ratios will have benefitted as inflation expectations climbed higher in October.
“In a low yield world, we encourage investors to seek alternative income sources. Private markets can offer long term investors an illiquidity premia, diversification from correlated public markets and an attractive cashflow stream. Ahead of the Budget Statement this month, it has been reported that the government is considering schemes to facilitate pension fund investment in a range of infrastructure projects. Such projects would likely offer lower liquidity but superior yield to government or corporate bonds.”
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