I was talking with someone who was pretty familiar with his employer's pension fund yesterday, and who also knows a bit about the economy.
He made an interesting comment. It was that his employer now holds no gilts in its pension fund. It has invested in much riskier corporate debt instead. This, as he put it, was being done in a 'chase for yield' and a need to 'match the liabilities'. In other words, the trustees have abandoned caution in an attempt to match income to their obligations. Short term accounting demands have made them leave prudence behind.
But, as he noted, this explains where the debt is in the UK economy. In 2008 it was on bank balance sheets, and they failed.
This time regulation will have reduced bank exposure so it is on pension fund balance sheets instead.
This does not matter, maybe, if there is no risk of another downturn. But that's exactly what there is now in the worldwide economy. And this time it looks like the pain could be a lot more personal for those who think their pensions can weather the storm if all are following this employer's practice.
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1) Corporate balance sheets have been substantially repaired during the period since the financial crisis, with higher yielding debt being refinanced at much lower market yields as interest rates have remained low. Because of this, default rates are substantially below historic averages, and companies are generally in a much better position to weather any downturn.
2) Any downturn will also see a fall in inflationary pressure, which is generally bond market positive.
3) QE has had the impact of sending investors such as pension funds further down the rate curve, and ultimately into higher rated corporate debt. This is not the trustees ‘abandoning caution’ as you term it, but because of an obligation, mandated by legislation, that certain liabilities need to be matched. (Something that Gilt investments are not able to do because their yields are so low, because of QE).
4) Tradeable corporate debt has always been primarily in the hands of investors such as pension funds and insurance companies, because they are the biggest participants in the markets. The present time is no different.
I look forward to being reprimanded by your regular contributors.
So, QE has created risk fir the next financial crisis
As I said it would in 2010
All you have done is confirm that
Well, that and a blasé indifference
Hi Richard, I think you are being a bit harsh there. 🙂 QE has caused risks by inflating bubbles, but more on Wall Street than in LSE. In the UK the bubble is, as usual, property prices. It would be very hard to say that the FTSE 100 is in a huge bubble when the index is only slightly higher than it was 20 years ago. Indeed allowing for inflation there has probably been zero change. What is in a bubble are gilts and all other bonds. They are not ‘safe’ any more than anything else. For example were you to buy a Treasury 4.75% 2038 Gilt today then this would cost you £153.56 per £100 face value. So on redemption in 2038 you will have a capital loss of £53.56 or a little over a third of your investment. In the meantime you will have had interest of 4.75% pa, but less say 2.5% inflation so a real return of 2.25%. If, as a pension fund probably would, you reinvested all the interest then it would just about make up for the capital loss leaving a very small less than 1% pa real return over the 19 years. The corporate bond will do rather better since the interest rates are typically higher. Unless there is a total World meltdown over the next 10-15 years I think it unlikely that major companies such as Vodafone, etc would be unable to repay their bonds. Of course the more speculative and risky you go the more likely that you will get duds.
A pension fund is really the classic long-term investor and they should follow a Warren Buffet style long-term value approach. They should be able to invest in e.g. some of the Green New Deal projects. Things that represent patient capital and are prepared to accept a return in 10 years rather than 3 months. To my mind sticking the money in gilts is just a ‘we will go for something ‘safe’ that we can’t be criticised or sued for, because we can’t be bothered or don’t want to take the risk of doing something more constructive’. The loser will be the future pensioner.
I have said for a while that the problem with private pensions in the UK (maybe elsewhere – but I don’t know) is that the more you demand guarantees and safety then the less you will get in the final pension. Indeed the only 100% safe guaranteed pension is no pension.
That is not to say that forcing folk into private pensions for all or most of their pension needs is a good idea. It isn’t and there is a good argument for saying that the State should provide a decent basic pension for all. It is the most efficient, least cost, and most reliable way to do it. Much too much of the personal private pensions vanish in charges and rents to the providers. Company Pensions were better, but Government policy over the past 20 years has totally destroyed the UK company pension scheme. I also don’t think it a co-incidence that the State has increasingly forced company schemes to invest more and more in Gilts. HM Treasury is hardly disinterested in ensuring there is a ready demand for them. Indeed when Apartheid South Africa was suffering financial troubles one of the first responses was to require SA pension schemes and insurance companies to invest ever higher proportions in SA gilts. The Nazi regime by 1945 required all German pension schemes, insurance companies, etc to invest 100% of their funds in German Government Bonds (which of course all ceased to have any value in May 1945).
I’d prefer the gilt
Indeed, that is my choice
Kent Brockman says:
” Corporate balance sheets have been substantially repaired during the period since the financial crisis, with higher yielding debt being refinanced at much lower market yields as interest rates have remained low. ”
Which is fine and dandy while interest rates remain low. Central bankers are praying for some inflation to justify base rate hikes because without the ability to cut interest rates in the event of a down turn there’s not a great deal they can do.
For your optimism about the improved state of corporate balance sheets to be justified it’s to be hoped some of these corporations are making use of cheap credit to invest in future productivity. Share buyback activity doesn’t augur well on that score. It is hard to avoid the conclusion that some boards of directors are considerably more interested in their own remuneration than the health of the corporations they manage.
Pensioners have to hope that their pension funds are doing their homework very thoroughly. I suspect 95% just go with the flow and do what everybody else is doing. It’s much less frightening to be wrong if everyone else is wrong with you, and you might still have a job.
Well said, Andy.
I don’t read into Mr Brockman’s comments a blasé indifference. He sounds like somebody who has real world bond market experience.
I’m also confused as to your apparent U-Turn on QE ? I thought from previous comments that you were keen to massively increase the supply of government debt at present low levels of yield to pay for your PQE projects ? Surely issuing further debt (I believe you were also in favour of some sort of hybrid local authority debt), would be, by your own estimation, also be creating massively more risk for the next downturn ?
QE and PQE are nothing like the same thing
I suggest you do some reading
I am sure there was a comment during the GFC from someone senior at HSBC to the effect that ‘sometimes it’s better to know you’ll get your investment returned than to get a return on your investment’. (Does anyone know who it was/have a link?)
OK Kent,
Having seen your comment I then typed 3 words into my Google search bar: “Corporate debt levels”. The immediate page 1 results from the top down are as follows:
$9 trillion corporate debt bomb is ‘bubbling’ in the US economy
https://www.cnbc.com/2018/11/21/theres-a-9-trillion-corporate-debt-bomb-bubbling-in-the-us-economy.html
Excessive levels of corporate debt are now the primary concern ..
https://www.businessinsider.com.au/corporate-debt-risk-fund-manager-survey-2018-11
These 5 charts warn that the U.S. corporate debt party is getting out of …
https://www.marketwatch.com/story/these-5-charts-warn-that-the-us-corporate-debt-party-is-getting-out-of-hand-2018-11-29
The U.S. Is Experiencing A Dangerous Corporate Debt Bubble – Forbes
https://www.forbes.com/sites/jessecolombo/2018/08/29/the-u-s-is-experiencing-a-dangerous-corporate-debt-bubble/#e74fa9c600e0
Should We Worry About Rising U.S. Corporate Debt? – Forbes
https://www.forbes.com/sites/cherryreynard/2018/07/30/should-we-worry-about-rising-us-corporate-debt/#3e96825b19c8
Corporate Debt Is Reaching Record Levels – WSJ
https://www.wsj.com/articles/corporate-debt-is-reaching-record-levels-11546099201
Fed Should Take Another Look at Corporate Debt – Bloomberg
https://www.bloomberg.com/opinion/articles/2018-11-29/fed-should-take-another-look-at-corporate-debt
The sub-headline for the last article (Bloomberg) read “Business borrowing is leaving little room for a cushion in a downturn.”. Anyhow, so then I thought, hmmm, this stuff is all from the US so I opened another tab and typed: “UK corporate debt levels” and the first 5 results were:
UK corporate debt soars to all-time high after years of low interest ..
http://www.cityam.com/266876/uk-corporate-debt-soars-all-time-high-after-years-low
United Kingdom Private Debt to GDP | 2019 | Data | Chart | Calendar …
https://tradingeconomics.com/united-kingdom/private-debt-to-gdp
Debt at UK listed companies soars to record high | Financial Times
https://www.ft.com/content/90672e50-7d0e-11e8-bc55-50daf11b720dUK debt could total £6.7 trillion by 2023, rising to nearly 260% of GDP
UK debt could total £6.7 trillion by 2023, rising to nearly 260% of GDP
https://www.pwc.co.uk/press-room/press-releases/UKEO-Nov-18-release.html
Household debt in UK ‘worse than at any time on record’ | Business …
https://www.theguardian.com/money/2018/jul/26/household-debt-in-uk-worse-than-at-any-time-on-record
And then I got tired of copy and pasting. So that’s not “being reprimanded”. That’s just how it is. I haven’t even read any of those items yet but I’ve got a fair idea of what to expect.
Precisely
I really do wish you would write this stuff up for Progressive Pulse…
I’m writing one for them at the moment on the US’ universal health care options. I was about to send it a few days a go and then the Green New Deal resolution went to congress and that kind of changed everything. So I’m rewriting now in that context. There will be more to come after that.
BTW this post of yours here really seems to have hit a nerve. Its brought them all out of the woodwork for some reason. I didn’t see that coming.
Nor did i
But they have their interests to defend
Their clients should ask appropriate questions
I would be pretty certain that the Pension scheme in discussion will have held a lot of Gilts and will have sold as QE pushed prices higher. So the Pension fund will have had a healthy increase in NAV and all the members benefit.
Until they don’t…..which is the point I was making
No it’s not really the point you were making at all.. they have basically brought forward investment returns they would have made in the future.
Look at it differently if I bought a 20 yr gilt at issue in say 2010 paying a coupon of 4% and I hold it to maturity then price moves (through QE) during the holding period is irrelevant.
Or if prices rise significantly during the holding period I can sell, capitalise on the rise in prices through QE, and invest elsewhere.
The Pension fund manager makes that choice, it’s what he is paid to do. No big deal..
The pension fund adviser is paid to produce quarterly feturns
They get everything else wrong
I stand wholly by my point
I bet you won’t by yours in due course
And I called 2008 right
So talking to an individual who has “some” knowledge of his employers pension fund is all the research you need to do before making bold and fatuous statements?
If pension funds shouldn’t hold corporate debt, what should they hold? I assume if you think they should hold corporate debt they shouldn’t hold equities either.
So what then?
It was not fatuous. It was informed discussion
The point that pension risk is the big issue this time is not fatuous
As many will find, to their cost
Pension funds have always held a large allocation to debt, be it government or corporate. It really is no different ‘this time’.
The fact that you have concluded that you would choose to hold a 19 year Gilt with a Gross yield of 1.58% (A Real Yield of minus 0.92%) within your pension is however informative, as your profess your discussion to have been.
It says I am appraising risk
I think others should as well
I called 2008 correctly
You can’t have a well informed discussion about the whole pension industry by talking to a single individual.
Pension risk is a big issue. But by buying and holding lots of Gilts which produce a negative return and which are already at incredibly high levels, you would be increasing that risk for pensioners, not decreasing it.
“I called 2008 correctly”
You seem incredibly proud of this, treating it like a medal which gives you the aura of infallibility. I’m sure you can then point me (via a link) to some articles you wrote BEFORE the 2008 crash happened predicting it.
I ask this, because after searching your blog, I can’t seem to find any articles you wrote in 2008 predicting a recession, until AFTER it had already started.
Predicting a recession after the fact is nothing to be proud of. Lots about tax, tax havens, tax avoidance, but no articles where you give your reasons for a coming crash and recession.
You also don’t seem to mention is that you have also forecasted recessions in 2010, 2012, 2013, 2014, 2015, 2016, 2018 and now 2019 as well. So basically every year.
Which says to me that basically you are always forcasting a recession, and that you are wrong a LOT more than you are right.
And that you are claiming to have done things that you simply haven’t.
Wow
Try the Green New Deal
Try January 2008
And try thinking instead of trolling
I looked through your posts from Jan 2008. In fact I looked through the posts from all of 2007 and 2008. None where you predict the 2008 recession. Certainly none I can find.
At best you link to a few other people’s articles where they say the economy isn’t going well.
I’m sure though, if you did predict the crash as you keep saying, you can easily point me to the article you wrote where you did so.
The fact that I can’t find it on your blog – with it’s very easy to use history – makes me think you didn’t predict the recession.
The Green New Deal has nothing to do with predicting a recession – and it is pretty clear you don’t understand the pensions industry from your other replies to people, so I guess you are just flannelling and calling people trolls because they are pointing out the vast problems with your article.
So pointing out how and why the market was overheated was not a prediction?
And writing a report on how to deal with the coming crash was not?
There are some people I cannot help
“So pointing out how and why the market was overheated was not a prediction?”
OK – give me a link to where you did this. Because I can’t find one. Not in your blogs here.
“And writing a report on how to deal with the coming crash was not?”
From the Green New Deal website:
“A Green New Deal was published on 21 July 2008.”
So AFTER the credit crunch had already begun, and about a YEAR after Northern Rock had already collapsed.
“The Green New Deal is a response to the credit crunch and wider energy and food crises, and to the lack of comprehensive, joined-up action from politicians.”
A RESPONSE.
Not a prediction then.
Looks like you are just making things up to stroke your own ego.
And who uncovered a great deal if the cause fir Nirthern Rock’s failure?
Please don’t bother to reply: trolls are really boring
Again I have been through your blog history and again I can find NOTHING suggesting you predicted Northern Rock’s failure. All your articles relating to it are post fact or comments on other people’s articles.
So, it looks like you didn’t predict Northern Rock either.
And I see you having given up claiming you predicted 2008 – it would be easy enough to link to the blog where you did so if you could. But you can’t, because you didn’t.
All other predictions of recession you have made have proved to be wrong…so all in all it looks like you aren’t exactly the best person when it comes to forecasting the economy. In fact, you have literally never got it right in over 10 years.
I politely suggest you can’t read….
I was the first person to ever discuss why Granite pulled Northern Rock down
So, with respect, you are simply not telling the truth
And obviously have no desire to do so
Just as you wholly misrepresent what was said on the GND
You will be deleted henceforth
And maybe retrospectively
“I was the first person to ever discuss why Granite pulled Northern Rock down”
Very punchy and some on here night believe you but it is t true. I was working at the time for JC Flowers. We had 2/3 of the firm sifting through Northern Rock as the Government were desperate. to find a buyer. We were given access to a lot of information not othrwise made public. Many firms like ours were doing the same. Suffice to say we didn’t bid for any banking assets inspite of the firm spending 1000s on man hours on it.
I have never heard of you until a friend brought this comment to my attention today.
http://www.taxresearch.org.uk/Blog/2007/09/17/northern-rock-the-questions-needing-answers/
Find it earlier in the media
Hang on, you told us you expect gilt prices to fall, but you’d be happy to hold a negative yielding gilt until they do ? What sort of risk are you appraising where losing money until you really lose money is preferable to simply holding cash ?
Do you know anything about the time value of money?
a pension fund ‘advisor’ is NOT ‘paid to deliver quarterly returns.
Where do you get this nonsense from, and why do you insist on talking about matters which you clearly have a limited understanding of?
How about because I talk to them? And that’s the pressure. Match the market, or else….
Which I most certainly understand, very precisely
You lot are really very worried, is all I can say
If your opening post is anything to go by, it’s quite clear that people you are talking to don’t have a clue and you don’t know enough to understand that!
Wow, this one got you going, didn’t it
Indeed, the ferocity of the reaction reveals all I needed to know about the herd thinking driving pension funds to excessive risk
We will pay a very high price for it
Investment grade corporate bonds equals ‘excessive risk’?!!!
What is the expected less on a typical AA-rated bond?!
The hubris before the fall
Bill Murray says:
“What is the expected less on a typical AA-rated bond?!”
That perhaps depends on the validity of the ‘AA’ rating ? Still……. if the guy at the next console believes it, it must be sound. Fundamental research: Tick. Due diligence: Tick.
The way they tell it, dodgy ratings agency accreditation was the lubricant of the 2008 debacle. But maybe that’s just urban myth ? Why worry it worked-out well enough last time.
[…] So, for the record, there is risk. Marco Fante has noted it, here. […]
Who has claimed that there is ‘no risk’ in corporate bonds?
Look for the investment grade comment
Understanding convexity is understanding risk. It isn’t a “crap model” made up by traders. It is a mathematical fact. Speak to someone at your uni who does financial economics, he will enlighten you. If you don’t understand convexiry you can’t understand the risk embedded in long dated gilts. End of story.
I can
I do
And there are factors beyond maths involved
Which is precisely why you are getting things wrong
Again
I can’t see anything that claims that investment grade bonds have no risk.
Please can you clarify?
I did….
[…] wrote a blog post on Wednesday called 'Where's the debt?' and another yesterday called 'That hit a nerve'. I have to say I am returning to the theme, […]
The approach is to separate the different forces. Like combining the momentum of several objects hitting into the xyz axis.
Rational economic man – return on investment over the duration for a pension fund. Pretty rubbish. So it’s an irrational investment after inflation and a little interest rate rise.
City trader – as long as you are not holding the parcel bomb who cares.
HM treasury – raiding once fat pension funds are easy they have no vote. Rig the rules and force the buyers to buy it.
Pension fund trustees- comply for fear of being made liable with losses. Safer amoungst the lemming crowd.
Short term politicians- spend the cash and kick the problem can down the street
Shareholders – losses from traders losses and fines, losses on insurance asset returns as listed companies try to fill the shortfall in the pension fund opening up, profits go down as costs go up from pension losses. Employees and Directors and Trustees all claim their past profit shares /decisions were justified. Shareholders lose legal actions trying to make them accountable. Auditors and accountants in the UK feast on the fees of the takeovers and avoid culpability as they advised Browns raid on pension funds and the dividend tax credit abolishing £5bn/yr.
Demand for matched duration AA assets exceeding supply by 3:1 or more.
So the supply demand curve creates a high Price of Gilts, so the yield goes down.
Economists and (maybe accountants) are dumbfounded that a rational intelligent market can make such a foolish price. Misleading the entire market.
Economists review their models looking for the missing greek letter marked ‘common sense’ which is not common.
Time for Shareholders to regain control via Shareholder Nomination to the Agm committee formation for all Plcs.
Regulators- avoid all responsibility as usual because they are devoid of thought or sense of prudence as they are advised by lawyers and accountants and the laws rules that were shaped by the above.
Taxpayers cry and pensioners weep.
You have been warned! By me.