What is happening with the bond market and how does it affect your pension?

Tim Price 8th Aug 2022 No Comments

Reading Time: 5 minutes

There is a financial market out there called the bond market which is worth over £100 trillion (yes, you read that right…well over £100 trillion).

Most of the time it barely gets a mention in the newspapers or on the television news.

Yet what happens within this global market has a crucial bearing on your mortgage payments, the value of our currency, the health of your pension fund and the interest rate you get on your savings.

Quietly, in the background, this market has been doing some worrying things in recent years. While it used to be seen as a relatively safe and non-volatile market to be in, it is now increasingly shunned by investors as it has been offering negative returns.

Tim Price, from Price Value Partners, who spent the first couple of of decades of his working life trading in the band market, explains the issues

• What is the bond market?
• What are bonds usually good for and why are they used in pension funds?
• What has been happening to the bond market?
• The current crisis in the bond market
• How the bond market crisis affects you
• Is your pension invested in bonds and, if so, what can you do about it?

 

What is the bond market?

 

The financial press likes to use the phrase ‘government spending’ to describe the government’s apparent generosity, whether in terms of funding the welfare state (the likes of state pensions or the NHS) or paying for schools or the police or the armed forces.

The sad reality is that the government has no actual money of its own. The money it spends is raised from the British people in the form of taxes.

Whenever government spending can’t be fully paid for out of general taxation, it borrows the shortfall in the bond market.

A government bond, also called a Gilt (short for ‘Gilt-edged security’), is simply a loan, an I.O.U. issued by the government, typically to an institutional investor such as a pension fund.

 

What are bonds usually good for? Why are they used in pension funds?

Let’s use the example of an actual UK government bond:

There is a 5 year Gilt which carries an annual interest payment of 1.25% and which matures (i.e. the debt is repaid) in 2027.

The series of cash flows will be as follows, assuming a purchase worth £1 million.

• In 2022, the institution buying the Gilt pays the government £1 million.
• Each year, for the next five years, the government pays the purchaser £12,500 (1.25% of £1 million).
• In 2027, the government pays the purchaser its final income payment of £12,500 and it pays back the original sum advanced (£1 million).

Bonds have long been deemed the most appropriate investment for pension funds in that they have fixed liabilities in the future (i.e. pension payments to pension scheme members) for which government bonds are regarded as the most appropriate way of matching those liabilities.

 

What has been happening to the bond market?

It’s crucial to appreciate one thing above all about bonds:

• if interest rates go up, bond prices go down. (Bonds need not be held until they mature; they can be freely traded every day, the same as stocks.)

To explain this, think about that five year Gilt again.

• When interest rates are at zero, that 1.25% yearly income is relatively attractive.
• But if interest rates were suddenly to rise to, say, 3%, then that 1.25% yearly income is much less attractive – and the price of the bond falls to reflect that fact.
• Given that interest rates are now rising from their lowest levels in 5,000 years, bond prices are duly falling – which means huge losses for institutional bond investors, including pension funds.

 

The current crisis in the bond market

Bond prices don’t just respond to changes in interest rates, they also respond to changes in inflation.

This is intuitively obvious:

• if you’re receiving a series of fixed cash flows (1.25%, say) then a substantial rise in the rate of inflation also makes those fixed cash flows less attractive – so bond prices also fall when the inflation rate goes up (or if the bond market expects it to go up in the future).

Most western governments have a budget shortfall which can only be funded through the issuance of government debt through the bond market.

How bad has the international bond market been this year?

The US, unsurprisingly, has the biggest bond market in the world. According to Edward McQuarrie, emeritus professor of business at Santa Clara University and an active miner of historical investment data, this year’s bond returns are the worst since 1842.

That translates to losses for bond investors running into hundreds of billions, if not trillions.

 

How the bond market crisis affects you

Bond prices move inversely to interest rates – the higher interest rates go, the worse the damage for bondholders.

That inflation is spiking higher is also bad news.

Higher interest rates will translate to higher mortgage rates for borrowers on variable rate mortgages, so it’s quite plausible that property prices will fall even as it gets more expensive for existing mortgage holders to repay their home loans.

The outlook for savers is more positive, of course, but cash deposit rates are still likely to remain some way below the official inflation rate.

 

Is your pension invested in bonds and, if so, what can you do about it?

It’s time to look at what is in your pension fund, if you haven’t done so for a while.

if you’re in a defined benefit scheme

• If you’re in a defined benefit pension scheme, it’s likely that government bonds will form a meaningful part of your pension pot.
• You may wish to ask your pension provider about the current composition of your pension fund.
• In extremis, you might want to consider taking the transfer value of your pension and moving it closer into your own control – and reduce your exposure to bonds in favour of other assets, perhaps including commodities and more defensive ‘value’ stocks which are likely to be a better hedge against interest rate risk and inflation.

if you’re in a defined contribution scheme

• If you’re in a defined contribution scheme, you may have more flexibility over the composition of your pension fund, but you may still want to reallocate your pension fund away from bonds, or move it onto a fund platform with the widest possible array of investment choices.

if you’re in a sipp (self-invested personal pension)

• Investors with Self-Invested Personal Pensions (SIPPs) will probably enjoy the greatest flexibility in terms of different asset classes and underlying fund selection. Check your SIPP to see what your money is allocated to and move it out of bonds and gilts if there is any there.

 

Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’.

 

This is not financial or investment advice. Remember to do your own research and speak to a professional advisor before parting with any money.