The spectre of negative rates is not a new one for trustees of UK pension funds. Real interest rates, which are returns adjusted for inflation and represent growth or loss in purchasing power, have long been mired well below zero. Fortunately, the UK has hitherto managed to escape the imposition of negative nominal rates, a controversial pillar of the ultra-accommodative policy which has become entrenched within the Eurozone and Japan.
The economic impact of the Coronavirus pandemic has prompted debate over whether the Bank of England should now join others in the negative rates club. Speculation over negative rates has been met with an equivocal response from the new Governor of the Bank of England, Andrew Bailey, and traders have taken note. The UK yield curve has quietly slipped into negative territory at shorter maturities. Investors buying gilts at these maturities are parking money in assets guaranteed, if held to maturity, to deliver a small negative nominal return and a likely large negative real return.
The principle of negative interest rates sits uneasily with fundamental tenets of finance. We are taught that money has ‘time value’ and that future cashflows can be ‘discounted’ back to present values. Where negative rates have become entrenched, these principles have been turned on their heads. Money invested at negative rates has no time value; on the contrary, it has a cost of carry. Negative discount rates are no longer discounting future cashflows, rather inflating them. Investors are not compensated, but penalised, for foregoing present day consumption.
These effects are not accidental. Negative rates are a feature of ultra-accommodative monetary policy that seeks to encourage those holding safe assets to seek out riskier sources of return. The effect, theoretically, is to disincentivise saving and incentivise investment, thereby aiding a nascent economic recovery. Companies have greater access to capital as investors are encouraged to shelter in corporate debt while shunning negatively yielding government debt – ‘moving up the risk curve’ in the jargon.
Pension funds however, bound by the constraints of gilts-based discounting and VaR, do not have broad latitude to move away from gilts. The effect can be perverse – rather than viewing gilts through the lens of risk and return as any other asset, trustees effectively become price insensitive and often increase holdings of these assets even as their risk and return metrics deteriorate. This behaviour runs counter to the economic rationale of imposing ultra-low or negative rates on the market, namely to tempt investors away from the absolute safety of government bonds.
The orthodoxy of gilts-based discounting cannot be viewed in isolation and must be placed within the broader economic context in which pension funds operate. Central banks have strayed far beyond their traditional remit of lender of last resort to become dominant players within financial markets. ‘Central banks are the only game in town’ has become a common aphorism on trading desks. In the US, the Federal Reserve has recently taken unprecedented steps to support markets, offering to buy both investment grade and some sub-investment grade corporate credit, in additional to treasury bonds. The Fed therefore sets not only the risk-free rate but increasingly the price of credit, and perhaps one day it will set the price of equity too. Within interconnected markets, its actions reverberate around the global economy.
The distortions caused by extraordinary policy mean that the industry must challenge the conventional wisdom of discounting on ‘gilts-plus’ and move towards one of a number of alternative approaches based on a prudent, but realistic, investment return on assets. Such a move would have beneficial consequences beyond merely incentivising trustees to adopt sensible investment strategies; it would help to broaden participation in corporate debt markets and perhaps even help to reduce the over-reliance of companies on bank funding rather than the capital markets.
The era of low interest rates has created challenges for trustees. Were low interest rates to become negative, these challenges would become acute and require redress. Our present reality is one of secular stagnation, quantitative easing and debt monetisation. Central banks have expanded their toolkits to confront these challenges, the pensions industry must do likewise.
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