Should pension schemes be worried about interest rates going negative?

With UK gilt yields at an all-time low, there still exists a train of thought that long-term bond yields are somehow bounded at zero and can only rise from here. Given Andrew Bailey, the governor of the Bank of England (BoE), has acknowledged that negative interest rates are in the BoE’s toolkit, we discuss the possibility of negative base rates alongside already negative gilt yields in the UK, and the consequences for UK Pension Schemes.

To get a sense of the view across the market, we have surveyed seven investment managers to find out their view on the likelihood of negative interest rates and the potential impact on the global economy and markets. We would like to thank Aberdeen Standard Investments, Bank of Montreal (BMO) Global Asset Management, BlackRock, Insight Investment, Legal and General Investment Management, Schroders, and State Street Global Advisors for taking part in this survey.

Key findings

We conclude that negative UK base rates is a plausible scenario and is closely linked to near term bond yields. Depending on the exact combination of circumstances this could exacerbate funding deficits through higher liabilities and lower expected investment returns. Most schemes should be concerned about the threat of lower interest rates, if they have not planned for it already.

  • Over half the managers felt that both base rates and long-dated gilt yields could fall below zero
  • There are potential knock-on implications for pension scheme liabilities, with inflation a relevant consideration
  • Holding physical cash is not the answer

"This is not a market for pension schemes to speculate in. The belief that interest rates can’t go lower has been defied by experience time and again." 

- Mark Minnis – Head of LDI research

Recent history of base rates and yields

Since the early 1980s and post the Oil crisis, we have continued to see the BoE base rate and gilt yields fall despite the global economy being in expansion throughout most of this period. Traditionally, one might have expected to see interest rates and yields increase over such a period of expansion.

At the end of September, the BoE bank rate was 0.1% and, as shown in the table below, the yield for all fixed gilts maturing in the next six years is negative. In others words you will be paid back less than the upfront cost of these bonds.

Recent history of base rates and yields (continued)

This phenomenon is not limited to the UK. We can see in the charts below the pattern of both base rates and government bond yields falling across the developed world over the last thirty years.

Sweden introduced negative rates in 2009 for commercial bank deposits although Sweden’s main policy rate (shown below) stayed positive until 2015. The ECB deposit rate the DFR went negative in 2014. 

On bond yields, Germany experienced negative bund yields on a number of occasions in the last decade starting in 2012. Japan’s bond yields became negative in 2015 along with a number of other European countries since. Corporate bonds are not immune either. Currently around 30% of all investment-grade securities and about 15% of all corporate bonds are offering negative yields.

Recent history of rates and yields (continued)

The fall in government base rates and bond yields can in part be attributed to the following factors:

Little threat of high inflation

We have not recently seen the high levels of inflation experienced in the 1970s and 1980s. The UK Government, amongst others in the developed world, have managed to keep inflation around their target. At the same time, in other countries like the US, inflation has been below target for the majority of the last ten years. The globalisation of the world economy (companies sourcing labour and materials across the globe) and the increased use of technology has reduced costs meaning that it has been easier for governments to loosen monetary policy without the fear of inflation getting out of control.

High demand for debt

Post the Great Financial Crisis of 2008 governments have been buying their bonds as part of their Quantitative Easing programs. Pension schemes, insurance companies and banks are also buying gilts and investmentgrade credit as a stable source of cashflow or to meet stricter reserving requirements. Despite the huge increase in the supply of debt across the globe over the last twelve years this appears to be matched by demand which has kept a lid on bond yields.

Do negative-yielding bonds make sense?

When an investor buys a bond with a negative yield it means that they are paying to lend money to governments and high-quality corporations. This may seem illogical – why would anyone want to pay for the privilege of lending money?

The reason is that for investors who want to hold a very secure and liquid asset, there are few other options than government bonds. Also when yields enter negative territory investors may have the belief that yields could fall further and therefore they could make a capital gain by selling the bond before it matures. In these instances the investor is not necessarily immediately focused on the current yield. 

In those countries where government bond yields are already negative (e.g. Switzerland, Germany, Japan), we also witness negative yields on high-quality corporate bonds. In this case, the additional credit spread over the government bond yield (to compensate for credit risk) is not sufficient for the yield on the corporate bond to be positive. Whilst this may appear irrational, in truth it simply reflects the intertwined nature of the financial markets.

'Cash under the mattress’ – Can you outperform bonds?
Experience in Japanese, German and some other European bond markets has shown both base rates and yields can and do go negative. While it’s tempting to think that physical cash in the form of cash and notes will give a higher return than negative yielding bonds, the reality is implausible. Firstly there are material ‘costs of carry’ from holding physical cash – i.e. logistics and security – which would result in a negative return on cash as well. The relatively modest cost of negative yields pales into insignificance compared to the potential for a cash stockpile to be stolen. This is on the assumption that the cash could be obtained in the first place. Any large scale withdrawal activity would lead to banks refusing withdrawals and long queues at cash points. 

Put simply holding cash is not a viable investment option at an institutional level.

What does the fund management industry have to say?

We surveyed seven investment managers who have expertise in bonds and Liability Driven Investment (LDI) for their views of the possible lower bound of UK base rates and gilt yields. We also asked for their views on inflation and the risks posed to the global economy of  negative interest rates. A summary of the questions and manager responses is shown below.

We asked...

Q: How much lower could UK base rates and gilt yields go?

The majority of the managers felt that interest rates could fall below 0% but would remain above -0.5%. Those managers believed negative rates and bond yields are a definite  possibility should the UK economy deteriorate further. Less than half of the managers felt that long dated yields would remain above zero. Those that did cited the Monetary Policy Committee who recently stated that ‘negative policy rates at this time could be less effective as a tool to stimulate the economy’.

Q: What are the potential consequences of negative base rates?

Asset price inflation (bubbles) in equity, commodity and property markets Many managers felt that continued support from policymakers would lead to asset price inflation and the valuation of risk assets being above their ‘true’ level.

Reduction of profitability of banks

 Some managers also cited that negative base rates could reduce the profitability of banks, which could lead to a reduction in the availability of credit to businesses, hindering credit markets and creating a strain on financial markets. 

Stimulating inflation was not considered an immediate issue 

The consensus among the managers we spoke to was that a negative bank rate might stimulate inflation, but not in isolation. They felt that inflation might be a secondary effect of a negative bank rate if it facilitates very high levels of government spending and fiscal stimulus.

Results of survey

What does this mean for pension scheme investments?

For pension scheme decision-makers, it is important not to assume that rates and yields cannot go any lower than where they are currently. Negative yields are already a reality and there is no floor on how negative they can go. 

Changes in gilt yields represent an unrewarded risk for pension schemes which means pension schemes should not expect to profit from being exposed to movements in yields unlike exposure to growth markets like equities and credit. Therefore, XPS is supportive of all schemes looking to reduce undesirable exposure to interest rate and inflation as far as practically achievable.

Key actions for Trustees

- Review your current interest rates and inflation hedge ratios in your investment strategy. Our view is that pension schemes should aim to hedge as much of their interest rate and inflation risk as possible while not sacrificing their other scheme objectives.

- If not currently utilised, consider the use of Liability Driven Investment (LDI) to better protect your scheme.

- Where maintaining sufficient expected return is a key requirement, consider synthetic assets to improve capital efficiency and to reduce unrewarded risks without sacrificing expected return. 

- Given the huge amount of monetary and fiscal stimulus in the market, be aware of potential asset bubbles. Stick with your long-term strategy and do not make short term tactical decisions.

In our survey, over half the managers felt that base rates could fall below zero. As we see from the history of base rates and gilt yields, the belief that yields can’t go lower has been defied by experience time and again. This is not a market for pension schemes to speculate in.

For further information, please get in touch with Simeon Willis or Mark Minnis.