Excitement x 3 – the election, bond sell-off, and Legoland…

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After the excitement of the Election, life returns to normal for the voting public, including pension trustees.
Normality for trustees should include having a clear plan for using bond market volatility as an opportunity to de-risk.

One of the implications of a General Election is that thousands of public buildings across the country have to be made available as polling stations. The knock-on effect for two of my children was an enforced day off from school, which the whole family duly spent at Legoland Windsor.

As we enjoyed our day out, I spent a reasonable amount of time surreptitiously looking at my phone – both checking what was going on in the markets and responding to the flurry of emails asking what was going on. The burning question seemed to be, “was the recent sell-off in bonds the beginning of the end?”

For those who have not been to Legoland, it sounds like a nice gentile and sedate place. It conjures visions of intricate models of global landmarks carefully crafted out of little plastic blocks. Now much of the park is very like this. There are pleasant boat rides through the fairy tale brook and a train that cruises gently around the park with its views of Windsor Castle.

There is, however, another side to Legoland, a darker world of Vikings and pirates, of roller coasters, log flumes and spinning things. If you want proof that Legoland can be exciting and turbulent, then this rollercoaster selfie should do the trick.

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It is a similar contrast to the unexpected that has prompted many of the questions of the last few days. Much to the consternation of pension funds, we’ve seen gilts march relentlessly upwards. The abrupt turnaround, with the 10 year yield rising by about 50 basis points over the last 6 weeks has surprised people and raised questions. The accompanying volatility in interest rate markets has left people wondering.

So do recent events herald the end of the gilt bull market and are we about to enter a period of dramatic straight line yield increases? I think it is right to expect yields to increase and there is likely to be some respite for pension funds that have seen their funding levels hit by falling yields. Keeping it in perspective, however, I don’t expect bonds to retrace all their gains. Volatility in interest rate markets is going to remain elevated.

I’ve highlighted in the past the increases we’ve seen in interest rate option implied volatility. As has been witnessed, this is a helpful metric to continue to watch insomuch as it provides a barometer of market volatility. The combination of stretched valuations, divergent macro-economic variables, low liquididty, and very different monetary policies around the world should keep volatility high. This was compounded last week by the election but that local factor is behind us now until the EU referendum surfaces.

At times like this, it is important to remain focused on the true balance sheet risks. The headlines in the papers tend to focus on the 10 year gilt yield. Most pension funds have longer dated inflation linked liabilities. These instruments tend to be less impacted by global factors and more a function of the needs of the domestic institutional investors.

The higher volatility in bond markets and other markets is an opportunity and the answer in this environment is to be prepared. Winding down leverage within the pension balance sheet and having some cash in reserve that gives the option to reinvest as more attractive valuations appear is sensible at this point.

 

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

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