Riding the waves of the bond markets

February 18, 2015 Categories: Investment Strategy, Liability Hedging

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Recent movements in the gilt market have reinforced the importance of ensuring that the design and implementation of a hedging strategy remains flexible enough to withstand market realities.

Over the last month, we’ve seen the yield on the 30 year gilt move from 2.40% on 8 January all the way down to 2.08% on 30 January and then rebound to 2.52% on 17th February.

The chart below plots the price of the UK Gilt 3.5% January 2045. This represents a change in value from peak to trough of 8.5%. A big move for a month and almost entirely reflected in the value of pension fund liabilities.

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There are two important themes at play here. The first relates to global macroeconomics and monetary policy, the second much more microeconomic and behavioural.

Divergent Monetary Policy

Much of the last month’s volatility in gilt markets can be explained by the divergent global monetary policy. A key investment theme for 2015. In January, we had a larger than anticipated QE announcement from Draghi, pulling down Eurozone sovereign yields and having a knock-on impact on the save haven asset represented by gilts.

Starting February, we’ve had another strong jobs number, altering expectations about the future path of tighter US monetary policy. US Treasuries sold off and yields increased, pulling gilt yields higher.

The gilt market, representing a small island in the Atlantic will continue to be pulled by tides of these two bigger forces, somewhat irrespective of domestic economic and political conditions.

Bank deleveraging & buy-side insensitivity

The extent of the move down in gilt yields on the last day of January is symptomatic of the current behaviour of gilt market participants. Since the financial crisis and with the advent of new regulations, investment banks are unwilling to absorb risk onto their own balance sheets. This is particularly acute at month ends and significant reporting periods.

At the same time, a number of buy-side participants have become increasingly price insensitive. If the strategy dictates buying gilts on the last day of the month, buy gilts they will.

This dynamic serves to exaggerate gilt market movements and can make trade execution more difficult. Reduced liquidity in the market is passed on in the form of higher spreads and transaction costs.

Lessons for pension funds

Many pension funds in the UK have recognised the importance of well balanced risk taking in their investment portfolio. For many, there is a plan to progressively increase the liability hedge ratio over time to right-size the liability relative risks.

This is without doubt a good idea. The experience of the past month has highlighted the importance of ensuring that the design and implementation of that strategy remains firmly connected to the market reality.

Remaining flexible in the implementation of a liability hedging strategy is of paramount importance, particularly in the current market environment. Don’t just float with the tide, but use it to your advantage.

 

David Rae, Managing Director, Head of LDI Solutions, EMEA

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