Fund Management

The Bond Yield Bubble

David Howell Investment Director February 2, 2006

The Bond Yield Bubble

Much has been written in the financial press recent weeks about the very low yields on long dated sterling bonds. The demand from the life c...

Much has been written in the financial press recent weeks about the very low yields on long dated sterling bonds. The demand from the life companies and the pension funds to shore up deficits prior to A Day when the Pension Protection Fund levy will be calculated has been huge.

The latest issuance from the UK Debt Management Office, a 50 year index linked bond, was over subscribed by 1.7 times and was purchased with a real yield as little as 0.46 per cent. With forced buyers from the financial world, the UK Chancellor, Mr Gordon Brown, must be extremely grateful in light of the growing budget deficit. He will either need to borrow more or increase taxes and, with an eye on the Prime Minister’s seat in rocky times for New Labour, he will not wish to put further doubt in the mind of the electorate.

As always, moves in financial asset prices are always overdone whether it be on the upside or the downside and, as many pension funds are having to meet financial liabilities which are calculated using a discount rate based on bond yields, the lower the yields fall the more they need to buy. A rather vicious circle and with such an easy game to play it is no wonder the hedge fund industry has jumped on the band wagon looking to make a quick profit.

The concern going forward is whether this bubble stays inflated and the pension managers’ remain buyers at such low yields. A gentle easing in prices is bound to occur as the Treasury taps the market with further issuances, but should the short term players believe that the capital profits have been made, then they will sell and without consequence to the long term holders.

In the short-term we would be sellers, but what else is there to buy? Place the proceeds on deposit and wait for a buy back opportunity; move across to equities and perhaps visit the utility sector, or even consider the shorter dated index-linked issues where the real yield is a more attractive 1.6 per cent. Some very old preference issues provide attractive yields. Whatever you may choose, don’t be tempted to sacrifice safety for riskier capital gain.

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