A quarter of the 60 trillion US-Dollar bonds issued by governments and companies worldwide are currently trading at negative yields – which means that 14 trillion dollar of outstanding debt is being paid for by creditors in a bizarre reversal of normal practice.
We have now reached a point, where negative yields have forced long-term institutional investors, such as pension schemes and insurance companies, to make unprecedented changes to their asset allocation mix as sovereign bonds can no longer deliver the returns needed to meet the promises made to retirement savers. Negative bond yields are a direct result of the vast asset purchase schemes introduced by central banks to stave off a worldwide economic slump after the financial crisis.
And the party of low interest rates looks to be far away from being over. Quantitative easing (QE) programmes were intended as emergency measures that would be withdrawn once it was clear that a sustainable economic recovery had begun. But with the ongoing trade conflict between the US and China (and no end in sight) slowly suffocating global economic growth, central bonus have embarked on a fresh round of liquidity measures to try to prevent a recession.
The Federal Reserve recently cut US interest rates for the first time in more than a decade, a change that the European Central Bank (ECB) is expected to follow. Speculation is also building-based on an EU economic slowdown – that the ECB will restart its bond-buying programme before the end of the year to try to stimulate economic growth in a moribund eurozone.
The interest rate cuts by the Fed and moves to ease monetary conditions in Europe, China and Japan will again drive pension funds and insurance companies to hunt for better yields in riskier assets. In our opinion this could be a dangerous cause of action, us many pension funds and insurance companies already increased their holdings of corporate credit, equities and structured products, as well so-called alternatives including private equity and real estate, after the 2007-08 financial crisis.
We at Calvin • Farel fear that some of these investors have been lulled into a false sense of security as reductions in US Treasury yields over the past decade were accompanied by strong gains for equities and a tightening in the spread (gap) between yields on corporate bonds and government debt. This correlation in our opinion only worked because the US economy did not fall into a recession. But if interest rates are going down because there is likely to be a sharp slowdown in global economic activity or even a recession caused by the trade conflict between US and China, then it does not make sense for pension funds to buy more risky assets.
The Fed’s monetary policy shift has already led to an inversion in the US yield curve (where short-term interest rates are lower than long-term rates), a historical warning sign that the economy could move into recession. The Fed in our opinion will have to quickly resort to unconventional monetary policy, notably QE, if the economic outlook turns sour as worries that a recession is looming before the end of next year is currently widely shared by investors, including us.
A US recession over the next couple of years in our opinion is possible, the Fed could respond in such a scenario by further cutting interest rates to zero and reigniting QE. Based on these assumptions it is for us difficult to see a change in the established trend for pension funds and insurance companies to take on more credit risk and to increase their exposures to alternatives, given the shift by the Fed, ECB and central bankers in emerging markets to relax monetary policy to support economic growth.
QE programmes and a decade of ultra-low interest rates have inflated stock markets worldwide. The S&P 500, the main US equity benchmark, hit on all-time high in late July, up to 347% from its past-crisis nadir in March 2009. Strong gains for stock markets over the past decade have helped many US pension schemes to narrow their funding gaps between assets and liabilities. We believe that many US pension funds would now like to buy more bonds to extinguish their liability stream but this has become difficult because of low interest rates. It is in our opinion impossible for pension funds to match their liabilities with where rates are today so they have to hope that equity markets will continue to rally. At the same time, US companies are deleveraging, which has shrunk the supply of new corporate debt, leading to a dearth of investment grade issuance. Net supply from municipal borrowers, another vital source of new issuance, has also turned negative so there is not enough available for pension funds and issues to buy.
US 10-year Treasury yields have dropped from 3.24% in early November to 1.88% following the Fed’s rate cut. These reductions in US interest rates will further increase the funding gaps faced by many public pension plans.
Pension schemes can counter these problems by increasing their holdings in high quality, long duration bonds. These include US Treasury STRIPs, investment grade bonds issued by non-cyclical companies, along with higher quality credits including commercial mortgage-backed securities from government-supported agencies such as Freddie Mac and Fannie Mae. Life insurance companies with long-dated liabilities can pick similar higher quality bonds that tend to do well in an economic slowdown along with short-dated securitized consumer credit.
The Bank of England could also be forced to cut interest rates to support the UK economy in the event of a no-deal Brexit. Declines in 10-year gilt yields, from 1.7% in September to just 0.55% have led to deterioration in the funding position of many pension schemes.
We warn that corporate pension schemes that do not already have robust hedges against unexpected changes in interest rates and inflation should consider increasing gilt holdings before yields possibly fall further. A fresh drop would in our opinion create bigger deficit problems of a time when cash flows at their parent companies are under pressure from the global slowdown and uncertainty over Brexit. Bonds account for more than half (54% on average) of assets held by UK pension schemes, according to Mercer’s 2019 European asset allocation survey. Hedging ratios vary widely by scheme but just over half of the 876 European pension plans surveyed by Mercer have hedging ratios of 80% or more in place this year.
Central banks in our opinion look determined to prolong QE’s sugar rush but that can only mean that the 14 trillion dollar headache caused by negative rates will remain unresolved for the foreseeable future.