LONDON -- British pension executives and their money managers are struggling to cover their long-term liabilities in the face of an overvalued and illiquid market for long-term U.K. government bonds.
The L2.6 billion ($4.1 billion) J. Sainsbury PLC Pension Scheme, London, is considering investing in U.S. Treasury inflation protection securities and similar international instruments if the plan is unable to get its hands on sufficient U.K. index-linked gilts, said Geoff Pearson, pensions manager and secretary.
"We are looking to extend our scope to make sure we are not paying over the top for U.K. instruments," but the fund does not need to increase its holdings of index linked-gilts now, he added.
"If we can't get this from the (U.K.) government, then we will go around the world to get it. There are much better returns in the overseas stocks which would more than pay for the hedging costs," he said. The Australian, Canadian, French and Swedish governments also issue inflation-proof instruments similar to the U.S. securities.
The problem has become so serious the government early next year will launch an inquiry into its debt program in an attempt to address the poor supply of much needed 30-year bonds and index-linked instruments.
Industry groups such as the National Association of Pension Funds are busy drawing up written evidence to be brought before the inquiry. Details on their expected testimony could not be learned.
Difficulty in large trades
London-based bond traders say bid-offer spreads on 30-year bonds have remained relatively static during the past few months, around 15 basis points, but it is now very difficult to trade in any size much over 10 million. "A few months ago we could have bought up to L50 million ($79 million) without a problem," said a fixed-income trader for a U.K. money manager.
The lack of liquidity is mainly the result of a sharp fall in the U.K. government's funding needs, following two years of budget surplus due to the tight fiscal policy of Chancellor of the Exchequer Gordon Brown. In early November the Debt Management Office, which manages public borrowing, canceled one of the year's two remaining auctions because of the government's budget surplus.
The lack of supply has been further exacerbated by the introduction in 1997 of the minimum funding requirement that requires domestic pension plans to match their liabilities with assets of similar maturities. Many pension plans also have been increasing their exposure to fixed income as they move to using customized benchmarks for investment, said Peter Rains, global bonds director for Morley Fund Management, London.
The subsequent rise in demand for long-term government bonds has caused yields to fall and prices to rise to extreme levels, and sources say the market is looking overvalued, bringing with it the risk of sharp falls in asset values.
By Nov. 23, the yield on the benchmark 30-year U.K. government bond was 4.26%, currently the lowest of any similar long-term government debt in the world.
Shift to corporates
With insufficient long-term government debt available to meet the demand, pension executives are attempting to invest in sterling-denominated corporate bonds, but at this stage these instruments are not recognized as a matching asset under the minimum funding requirement. Nor are pension funds easily able to diversify into the more liquid euro government bond markets without incurring currency risk.
The Institute of Actuaries is working on proposals to make the MFR more flexible. Proposals are to be published next March, but it could take another year before the legislation is changed to include corporate bonds in the definition of matching assets.
Plan sponsors most vulnerable to the current high cost of long-term bonds are those with a large number of pensioners and a relatively small proportion of active members.
Smaller funds, generally with assets of less than 10 million, also might be vulnerable. Many of them have only a limited surplus and could see asset values eroded if long bond prices were to fall. Diversifying into corporate bonds might not be the answer for such plans, as these assets can carry risks that the plan may not be able to afford, said Mike Pomery, a partner at Bacon & Woodrow, London.
Large stock moves hurt
Very large funds also might have problems covering their long-term liabilities as they are having difficulty buying stock in large amounts.
Plans with assets larger than the market capitalization of the sponsoring company also might have difficulties: The sponsor may not want the fund to take on too much risk if the liabilities are not effectively matched, said Peter Thompson, senior consultant for William Mercer, London.
The heavyweight L26 billion ($41 billion) British Telecommunications Pension Scheme, London, has only 4% of its assets invested in U.K. gilts and plans to reduce this exposure to 3%, said Colin Hartridge-Peel, chief pensions officer.
Roughly 8% of the fund is invested in index-linked gilts. Fund trustees prefer to maintain a large exposure to equities, he said. Nonetheless, as a large fund it can be difficult to find sufficient stock to fill even a small portfolio.
"If pension funds do want to match their liabilities, then long-dated bonds need to be more easily available," he said.
The current illiquidity in the market will be solved only if the government issues more debt. Tinkering with the MFR is not the answer, he said.
Mercer's Mr. Thompson believes corporate bonds are a much more attractive instrument for matching liabilities because of the current cost of buying long-term government and index-linked bonds. "Some might take the view that the yield enhancement on corporate bonds could take out some of the risk of these instruments," he added.
Although it is a statutory requirement to have the plan measured in terms of the MFR, funds are not obligated to invest in specific asset classes, said Bacon & Woodrow's Mr. Pomery. But those plans that are not adequately funded as measured by the MFR have to restructure their portfolios and increase their exposure to long-term bonds.
