Money matters
Jan. 22nd, 2006 12:40 pm![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
peterbirksEntertaining times in the gilts market. About 18 months ago I went to a day's seminars on asset management (oh what an exciting life I lead). The man in charge of fixed interest investments at Threadneedle gave a talk and observed that index-linked gilts, which had been rather popular over the previous nine months, might be at their peak.
Well, he was slightly wrong.
A bit of background. Suppose you have a lot of money now and suppose that you want to invest it to cover liabilities that will appear 30 years down the line. In other words, suppose you are a fund manager for a pension scheme. Now, fund managers, not being the brightest of beasts and being particularly keen on "doing what the others are doing", notice that index-linked gilts are getting popular. The reason is not hard to find and can be linked to the recent increase in the price of gold in spite of the dollar being strong. People are finally sussing that inflation, far from dead, may well make a reappearance, if not sooner, then at least in the medium term.
Unfortunately, knowing or even suspecting that something is going to happen doesn't necessarily do you much good. You have to know what to do with the information. For the fund managers, they could see no more than "buy index-linked".
This would be fine if there were a limitless supply, but there isn't. The 2055 issue now offers a real yield of only 0.48 per cent - at one point this week it was 0.38 per cent. This compares with the 1.1 per cent at which the bond was issued last year and the 2 per cent at which most index-linked offers were made. Now, a return of inflation plus 0.38% is basically costing you money (for the same reason that the guarantee that pensions will go up with inflation rather than in relation to earnings inevitably means that pensioners get poorer -- real output increases and we get wealthier in real terms).
Now, one could argue that the 0.38% might look bad, but if the rest of the investment market is going to collapse, it might be good (also known as the "mattress investment fund", which in an idle moment I half-heartedly thought of launching. "Give me your cash and I guarantee you the same amount back in five years, no matter what happens to the markets").
However, this line of argument collapses in the face of the fact that Treasury Income Protected Funds (Tips) — the US equivalent of UK index-linked gilts — are offering 2%, what one might call the "proper" risk-adjusted rate.
In other words, the return on UK index-linked gilts is so low because a large number of rather stupid people (who are paid far too much), are buying them like sheep, thus pushing up the price. That doesn't mean that the price will fall in the near term (although it does make them a bad investment in the medium to long term). As in poker, the short-term in the markets is longer than you think. But Chris Fellingham, managing director of fixed income at Merrill Lynch Investment Managers, summed it up right earlier in the week when he said that it is perfectly sensible for pension funds to look at asset-liability matching but they should make some sort of valuation judgment before buying index-linked bonds.
Which could turn out to be one of the financial understatements of the year.
Now, what I would like to know is, how can one exploit this disconnection between UK index-linked offerings and the US Tips? There has to be a way, but I just can't see what it might be. God, I thought that there was a derivative for everything these days?
Well, he was slightly wrong.
A bit of background. Suppose you have a lot of money now and suppose that you want to invest it to cover liabilities that will appear 30 years down the line. In other words, suppose you are a fund manager for a pension scheme. Now, fund managers, not being the brightest of beasts and being particularly keen on "doing what the others are doing", notice that index-linked gilts are getting popular. The reason is not hard to find and can be linked to the recent increase in the price of gold in spite of the dollar being strong. People are finally sussing that inflation, far from dead, may well make a reappearance, if not sooner, then at least in the medium term.
Unfortunately, knowing or even suspecting that something is going to happen doesn't necessarily do you much good. You have to know what to do with the information. For the fund managers, they could see no more than "buy index-linked".
This would be fine if there were a limitless supply, but there isn't. The 2055 issue now offers a real yield of only 0.48 per cent - at one point this week it was 0.38 per cent. This compares with the 1.1 per cent at which the bond was issued last year and the 2 per cent at which most index-linked offers were made. Now, a return of inflation plus 0.38% is basically costing you money (for the same reason that the guarantee that pensions will go up with inflation rather than in relation to earnings inevitably means that pensioners get poorer -- real output increases and we get wealthier in real terms).
Now, one could argue that the 0.38% might look bad, but if the rest of the investment market is going to collapse, it might be good (also known as the "mattress investment fund", which in an idle moment I half-heartedly thought of launching. "Give me your cash and I guarantee you the same amount back in five years, no matter what happens to the markets").
However, this line of argument collapses in the face of the fact that Treasury Income Protected Funds (Tips) — the US equivalent of UK index-linked gilts — are offering 2%, what one might call the "proper" risk-adjusted rate.
In other words, the return on UK index-linked gilts is so low because a large number of rather stupid people (who are paid far too much), are buying them like sheep, thus pushing up the price. That doesn't mean that the price will fall in the near term (although it does make them a bad investment in the medium to long term). As in poker, the short-term in the markets is longer than you think. But Chris Fellingham, managing director of fixed income at Merrill Lynch Investment Managers, summed it up right earlier in the week when he said that it is perfectly sensible for pension funds to look at asset-liability matching but they should make some sort of valuation judgment before buying index-linked bonds.
Which could turn out to be one of the financial understatements of the year.
Now, what I would like to know is, how can one exploit this disconnection between UK index-linked offerings and the US Tips? There has to be a way, but I just can't see what it might be. God, I thought that there was a derivative for everything these days?
![[identity profile]](https://www.dreamwidth.org/img/silk/identity/openid.png){kind=small}
no subject
Date: 2006-01-22 08:57 pm (UTC)I thought that there was a derivative for everything these days?
Hopefully not, since I've just started work for a structured product business... Actually, we're targeting the asset managers, who are apparently not the sharpest tools in the box when it comes to derivatives, but are smart enough not to trust the investment banks, so they're going to turn (we hope) to asset managers who specialise in "clever" maths-type stuff. If this turns out to be the case then that can onl be good for me. If it doesn't, well, there are other jobs.
no subject
Date: 2006-01-23 07:22 am (UTC)PJ
no subject
Date: 2006-01-23 09:17 am (UTC)If I understand any of it at all yet (debatable) then the idea is that we cook up the product that gives the client the protection/exposure they want/need, but we then put the market-making aspect out to a third party, with whom we'll trade on behalf of the client. The third party will be a bank. This, apparently, is a good thing - firstly we don't have to run the opposite side of the trade with all the hedging, risk management and capital useage entailed, secondly it's more "transparent". Well, that's what they tell me.
Damn
Date: 2006-01-22 10:10 pm (UTC)Given the sorts of trouble pension funds have had with asset-liability mismatches, it's no surpirse that people have become over-cautious. When LloydsTSB bought Scottish widows, their due-diligence team looked at the books, and then called HSBC for their price in a yard of the longest gilts available (don't remember if it was I/L or conventional). HSBC's ensuing short distorted the market for weeks afterwards.
Re: Damn
Date: 2006-01-23 07:23 am (UTC)PJ
Re: Damn
Date: 2006-01-23 05:47 pm (UTC)Re: Damn
Date: 2006-01-23 07:30 pm (UTC)Pete
Re: Damn
Date: 2006-01-23 09:22 am (UTC)If the yield's artificially low, then you're probably going to have to hold them to maturity to achieve the yield, as any correction is going to thump the price. Or am I missing something - I'm not especially au fait with the behaviour of linkers. Come to think of it, I haven't really had much to do with the bond markets since 1997.
Re: Damn
Date: 2006-01-23 09:44 am (UTC)Or, to add yet one more too many "Ors", remember LCTM and the discrepancies that they gambled on. "Whoops, the discrepancies just got bigger. THAT wasn't meant to happen."
PJ
Re: Damn
Date: 2006-01-23 11:28 am (UTC)Which is what Abbey National Treasury Services neglected to take into account - to cost cost of about £1bn. Just after I started work there, dammit.
I agree that the things could continue to go up - I think they probably will. Google shares, too. I can't see index-linked being a particularly good buy-and-hold-to-maturity trade right now, though: I think there would be alternatives that offer substantially better potential returns for a relatively small amount of risk, given the dearness of the linkers. But I'm not looking for any just now since I'm busy sinking my money into what is (thus far) just a concrete-filled hole in the ground.
no subject
Date: 2006-01-23 01:01 pm (UTC)I have rather a nasty position in these for the hedge fund (boo hiss) I work for! The real interest rate on long linkers is very low, but short dated ones reflect current policy against inflation rates. This means forward real rates such as 15y real rate in 15 years times has traded at zero. This needs some explaining.
As I understand it:
Firms with defined benefit schemes can measure their funding exposure using these linker rates and longevity tables. Any shortfall is reported as "Pension Blackhole" or less alarmingly as funding shortfall. If the firm makes good this shortfall the only way to properly hedge is to buy these linkers. If they buy something else that underperforms they fall back to being underfunded. If what they buy (equites presumably) outperforms the PENSIONERS keep the benefit, the firm won't get the outperformance back. They could run an underfunded position invested in something instead of linkers but if linkers go up (in price) their position in the short term looks worse... Most of these firms aren't investment experts so just want out of their position - they buy linkers, their arent enough ergo carnage.
This might look bad but then consider public sector pensions. There's 20m of them, their benefits are still accruing and they retire at 60.
Many firms are closing defined benefit schemes to new entrants or even further contributions. Do you think Gordon's gonna do the same?
best wishes
skills (1.13 to 1.1 is 3bps)
no subject
Date: 2006-01-23 02:06 pm (UTC)I think I see what you are getting at here, in that if the fund managers buy something other than ILs, then the pension fund managers lose either way. I had thought that they would gain if the investment overperformed, but, of course, they don't.
Of course, one's sympathy for firms is limited here, since for many years the firms DID keep the benefit, in the form of pension contribution holidays (partly, I admit, because of the farcicl government restrictions on the level of "overfunding" you were allowed to keep in the fund — 105%, I believe), so one might say that any outperforming achieved by an investment in, say, equities, deserves to go to the pensioners, while any underperformance deserves to come from the companies. But, well, you and I know that in the real world, things don't work like that. All those pension holidays resulted in the money going somewhere else — dividends, mad takeovers, CEO bonuses, whatever — and not into a cookie jar on the shelf on the 14th floor.
Now, as for public sector pensions. A different area entirely. These are completely unfunded. And in local government I foresee a time when the back will break. All of the council tax will be going to pay pensions and none of it to pay for services. Eventually, either the people will say enough is enough, or some other radical change will occur. More likely is that a fudge will emerge with the level of pensions falling in real terms (see inflation, return of, reasons why it will happen).
Central government-funded pensions will survive longer but, eventually, retired civil servants will be living too long and something will have to be done. Central governments have more power, and if the general support of the country is there, these pensions will be inflated away faster, when it eventually happens.
As I've said before, anyone with a final salary pension scheme, index-linked or not, is likely to be rioyally fucked, one way or another, before they die. Me, I've got a money purchase scheme, and I can invest it roughly how I wish, and it's MINE (heh heh heh).
PJ