Operation Steepener

Operation Steepener?
Bond markets in the developed world are not being run with the lender/investor in mind. The purpose of loose monetary policy and quantitative easing (QE) is to reward the borrower or at least to make it cheaper to access debt. For investors in debt/fixed income and balanced mandates you need to bear this in mind even though you’ve enjoyed good returns from your bond investments.
Nowhere is this more manifest and the evidence more stark than in the soaring pension fund deficits in the UK as a consequence (unintended we presume) of plummeting long gilt yields.
Mind the Gap
Unintended we ask because if companies have to set aside funds to make good the increased gap between liabilities and assets to cover their pension deficits, for many companies the attraction of lower interest rates is severely diminished. The following graph from Modern Investor magazine using data from Mercer illustrates the decline in the percentage coverage of pension liabilities via the solid green line (right hand scale) and the size of the deficits (left hand scale) of FTSE 350 companies.  Note the deterioration in both so far in 2016.
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Stick or Twist
Is the Bank of England concerned about this phenomenon or do they see that as a future problem while saving the economy from recession is a clear and present danger? Yes, they have made borrowing cheaper across most but not all maturities but increasing the borrowing requirements of companies to cover pension liabilities rather than productive capacity, seems counterintuitive.
There is however a recent precedent that might help the Bank of England in their quest without inflicting damage via unintended consequences of their QE policy.
In September 2011, the US Federal Reserve sought to manipulate the shape of their yield curve in order to keep a lid on long-term interest rates. This was important because unlike the UK, most mortgage rates are priced off thirty-year US government bond yields and it was keen to avoid rising mortgage rates which could hinder the housing recovery.
If we look at the yield changes that have occurred across the maturities of UK government bonds (gilts) since the Bank of England’s announcement of a quarter-point interest rate reduction in the bank rate to 0.25% and an extra £60 billion in QE (£50 billion in gilt purchases and £10 billion in investment grade corporate bonds), we can see from the graph below that long-dated yields (seven years and longer) have fallen but yields between one and five years have risen. Admittedly the margins are small but not insignificant if you ask those impacted.
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Source: Bloomberg
While holders of bonds where yields have fallen have benefited from a capital appreciation, the actuarial impact of the decline in long rates has a far greater impact on future pension fund liabilities.
Most UK businesses’ loans, especially small and medium-sized companies plus residential mortgages, are priced on a floating rate basis relevant to the Bank Rate or through short-term fixed loans out to five years. The bigger problem for those borrowers is that they receive the benefit of any interest rate cut from their lender who doesn’t resort to increasing their margin as the Bank Governor was at pains to point out on August 4th.
Twist and Shout
Why then doesn’t the Bank of England take a leaf from the US Federal Reserve playbook and buy more short gilts where they have the most influence on the borrowers they are keen to encourage and stop competing with pension funds in buying the limited supply of long-dated bonds. In fact, let the government borrow money at around 1.25% for 50 years as part of a fiscal expansion in the Autumn Statement as part of a better balance to monetary and fiscal policy.  Pension funds would like to buy them even if yields rise.
As we have said before, monetary policy has reached its limits and probably gone beyond them in Europe and Japan. As we stated at the outset, The Bank of England is on the side of the borrower not the fixed income investor.  We get that message and only hold managers with a specific brief in our multi-asset, Dynamic Fund albeit in a small allocation.  Most bond markets are trading like commodities, driven by the needs of central banks, pension funds and yield-seekers.  At negative real interest rates (below inflation), most offer poor value.

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