Cover story – Coronavirus
ue to monitor the government’s current advice and are reviewing our position daily via a tactical working group. “We are in regular touch with our key suppliers on their ability to maintain their services and continue to take all reasonable steps to maintain current business as usual service. Our aim is to do our best to keep disruption to a minimum,” he adds. With stock markets reporting the sharpest sustained decline since 2008’s financial crisis, a focus on equities can be painful, particularly if the scheme in question is also in the process of completing its valuation, as is the case for the country’s biggest final salary scheme, the £69.4bn Universities Superannuation Scheme (USS). In line with FRS102 guidance, the scheme’s as- set values will be based on a snapshot of asset prices at a set date, in this case 31 March. While results are yet to be deter- mined at the time of writing, they are unlikely to be flattering; 60% of the assets in the scheme’s Retirement Income Builder fund are held in equities. Shortly after launching its valuation process, USS announced that it had reported itself to the regulator after breaching its in- ternal self-sufficiency measure on five consecutive days this month. USS uses the self-sufficiency measure to estimate the level of low risk “self-sufficiency” deficit at the current levels of 10% employer contributions annually during the next 30 years. With the referral to the regulator, USS’ board is likely to make the case for an increase in deficit contributions because of fall- ing investment returns combined with rising gilt yields.
Bond volatility Having said that, questions are being raised over whether gilts should still be a benchmark of investment returns and if they are the risk-free assets they are believed to be. Throughout March, gilt yields were characterised by sharp vol- atility. Earlier that month, yields on long-dated assets fell sharp- ly, causing warnings that liabilities could spike by between 15% and 20%, according to River & Mercantile. But just weeks later, gilts, like other sovereign bonds, faced sudden selling pressures in response to the Coronavirus crisis. On 19 March, UK bonds had been on course for their biggest sustained fall since 1998, which was only halted by the Bank of England cutting rates to 0.01%. After a decade of record low re- turns, 10-year gilt yields suddenly surged by 70 basis points. Robin Ellison, a consultant at law firm Pinsent Mason, has a warning despite the rise in the return on the risk-free rate. “Re- gardless of the volatility and the price, dealing in bonds has be- come difficult. With traditional liquidity providers like invest- ment banks no longer in the market, the standard advice that bonds are a safe haven has been slightly tarnished. “In theory bonds should be less volatile but that has not been the case and there are times when bonds are less marketable than equities,” he adds.
22 | portfolio institutional April 2020 | issue 92
The reason for the falling confidence in UK sovereign debt is only partially related to the Coronavirus crisis. One the face of it, this suggests that investors are starting to ask questions about the sustainability of the government’s latest borrowing spree aimed at tackling the crisis. At the time of writing, the Chancellor of the Exchequer has pledged £350bn in loans and tax breaks to support businesses. At the same time, the Bank of England committed to buying £200bn of UK government and investment-grade corporate debt, bringing the total volume of its quantitative easing measures to £645bn. So why the con- cerns about liquidity?
A more complex underlying factor might be the structural change in the nature of bond market liquidity providers that took place in the aftermath of the global financial crisis. With banks having retreated as the main liquidity providers to the bond markets, principal trading firms have increasingly emerged as market makers. But unlike banks, they tend to have small balance sheets and trade large quantities of securi- ties by hedging the relevant assets, therefore, keeping a zero- net exposure.
Investors are now raising concerns that in the event of sharp volatility, they might be more reluctant to hold opposing posi- tions and simply sell the assets that are easiest to liquidate to meet margin calls.
Another factor complicating risks in bond markets are poten- tial liquidity mismatches in bond funds. Fund managers for supposedly liquid bond funds have gradually edged up the risk curve to improve returns, a move that could now come back to bite them.
The flipside of a potential rise in gilt yields is that it could have short term beneficial effects on liabilities, which tend to be cal- culated in reference to long-dated debt yields. In November last year, a marginal increase in bond yields wiped off more than £20bn from the FTSE350 pension scheme deficit within a month. However, with volatility of gilt yields remaining a con- stant factor due to the changing nature of liquidity providers, it is uncertain whether these benign effects will be long lasting. Having said that, the crucial element for many DB schemes should now be a focus on immediate cash-flow requirements, rather than worrying about deficit figures in the abstract, ac- cording to Ellison. “Most pension schemes I work with are des- perate for a buyout in the next year or so and we’re looking at a six-year project. “So if the stock market collapses for a year or two it’s not the end of the world,” he adds. “Unless they need the cash, and some schemes do need the cash.” For defined benefit schemes, the main elephant in the room will be the strength of the employer covenant. Risks are par- ticularly high for some of the biggest final salary schemes in the country, where pension scheme assets exceed the sponsor’s
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