Pension funds pay the price for bond market distortions


The recent fall in bond prices and consequent rise in yields will come as a boon to deficit-prone pension funds.

Future pension obligations are discounted by a rate derived from bond market yields. A rise in the discount rate shrinks those liabilities, and deficits also shrink in the absence of a material fall in the value of the fund’s assets.

The other big beneficiaries of the rise in bond yields are value investors. They have been bruised for years thanks to their lack of exposure to the big tech stocks that have driven equity markets to heady levels.

Discount rates played an important part in the tech stocks’ rise because the long decline in bond yields caused the net present value of the tech companies’ strong future cash flows to balloon.

Bill Gross, co-founder of the Pimco fund management group, has estimated that a drop of 1.5 to 2 percentage points in real long-term interest rates can boost the price of Apple or Amazon by as much as 50 per cent, other things being equal.

With interest rates now rising, the discounting logic goes into reverse, shrinking the net present value of the growth companies’ future cash flows. But the adverse impact of the rate rise for value stocks is offset by enhanced earnings prospects from the reopening and recovery of pandemic-hit economies.

Yet there is a tricky question to be asked as to whether the values thrown up by discounting at historically freakishly low interest rates make much sense. They are the product of a market that has been systematically rigged by central banks whose balance sheets have been stuffed with a multitude of government IOUs since the global financial crisis.

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Today’s long-term gilt yield of 1.2 per cent compares with yields that ranged from just over 2 per cent to 6 per cent in the two and a half centuries before the financial crisis, according to A History of Interest Rates by Sidney Homer and Richard Sylla.

And in the parts of the global bond market where negative yields prevail, the concept of the time value of money borders on the perverse since the present value of today’s pension liabilities is greater than their value in the future.

The winners from ultra-loose monetary policy have been asset owners including, conspicuously, homeowners. But their gains have come at a political cost. The resulting wealth inequality has fed a populist backlash across the developed world.

This year’s rise in bond yields is an early warning of trouble to come. The exit from unconventional central bank measures will be infinitely harder than the entry because policy rates cannot be raised to address any looming inflationary threat without inflicting serious financial instability along with economic recession, or worse.

Central banks will now be under increasing political pressure to keep government borrowing costs low by extending their bond buying into longer durations and keeping interest rates from rising above a given target — yield curve control, in the jargon. That would point to more bubbles and, as long as actuaries and pensions regulators slavishly adhere to distorted “market” benchmarked discount rates, to continuing inflated valuations of pension fund liabilities.

This will be tough on sponsoring companies that have been pumping money into their defined benefit pension schemes to quell burgeoning deficits. And there are wider economic consequences because there has almost certainly been a reduction in risk appetite in boardrooms, which may have been a contributory factor in low rates of investment since the financial crisis.

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There is an obvious, simple solution to this problem, namely historical averaging of the interest rates used in discounting liabilities to present values. Yet it is hard to make a case for what would be perceived as a loosening of valuation rules when pension fund scandals at British retailer BHS and elsewhere are fresh in the memory.

The irony is that the actuaries’ embrace of market fundamentalism is a recent phenomenon. In many countries in the 1960s and 1970s, they ignored market values when valuing assets and preferred instead to discount their own estimate of future pension fund income, usually at the same rate as they discounted the liabilities. Result: a magical balance whereby the value of assets and liabilities was immune to shifts in interest rates.

john.plender@ft.com



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