CHANGES IN THE BOND MARKETS - Retirement Provision in Scary Markets

For some companies with a DB pension fund, the size of their pension schemes and the volatility of the fund’s surplus can make their overall prof- itability more dependent on the performance of the pension fund rather than the performance of their core business. For example, the estimated

asset–liability shortfall of General Motors pension scheme is US$16 billion – a figure roughly equal to the market capitalization of the entire company.

For a DB fund, where the future obligations of the fund are more or less known, bonds can be used as an investment strategy to match those liabilities – an approach known as immunization. Boots in the UK were one of the first to switch their DB fund into bonds in a profile that matched their ongoing liabilities. The move towards immunization has been encouraged by accounting standards such as FASB 87 (Financial Accounting Standards Board) (in the USA) and, more recently, FRS 17 (Financial Reporting Standard) (in the UK).

These accounting standards require changes in the surplus of a DB fund to be included in the company’s profit and loss on a marked-to-market basis.

Arguably, shifting from equities to bonds is trading off shorter-term stabil- ity against a longer-term increase in the funding costs. Over a 10- or 20-year time horizon it is difficult to argue that an immunized bond portfolio will produce a better return than a portfolio with a significant allocation to equities.

But, for the companies themselves, it can mean a return to a focus on their core business rather than an unwelcome push into becoming a life assurance company. Other DB funds have followed Boots in their shift into bonds.

Figure 3.1 shows long-term rates since January 2000 for the UK. The decline in rates is typical of rates throughout the major markets. Significantly, long-term rates (as indicated by the 30-year swap rate) have been lower than ten-year rates for much of this period. Anecdotally, this is as a prolonged effect of the introduction of the FRS 17 standard.

Figure 3.1 Declining longer-term interest rates

Jan 2000 Mar 2000 May 2000 Jul 2000 Sep 2000 Nov 2000 Jan 2001 Mar 2001 May 2001 Jul 2001 Sep 2001 Nov 2001 Jan 2002 Mar 2002 May 2002 Jul 2002 Sep 2002 Nov 2002 Jan 2003 Mar 2003 May 2003 Jul 2003

7.0 6.5 6.0 5.5 5.0 4.5 4.0

UK 30-year swap rate (per cent) UK 10-year swap rate (per cent)

In Australia, most superannuation funds are accumulation funds. There has not been a pronounced shift to immunized bond portfolios. However, the ageing demographic of superannuants will tend to increase the role of bonds.

As they shift from accumulating assets to consumption, equities will become a riskier investment, and capital-stable, income-producing assets, such as bonds, will become more attractive. The extent of this shift remains to be seen.

Doomsayers have forecast a generation-long shift from equities to bonds, lead- ing to asset price deflation that will eat away at the retirement provisions for Generation X following the Baby Boomers’ wake.

The extent to which demographic shifts and moves from DB funds towards immunization will increase the demand for bonds is unclear. However, changes on the supply side over the last decade have been pronounced and have caused a fundamental shift in the way in which bond portfolios are constructed.

In Australia, government borrowing has been in decline since 1996 (see Figure 3.2). The mooted sale of the government’s remaining share of Telstra would have raised sufficient revenue for Treasury to redeem all government bonds. This provoked a debate on whether the Australia government should be debt free and whether the Australia economy needs a sovereign risk debt market.

In the end, the sale of Telstra failed to gain sufficient political support and the structure of the nation’s balance sheet with no net debt was not revealed. This is not the first time this issue has been visited. In 1989/90 the government under- took reverse bond tenders and the end of the treasury market was forecast. This was unwound as the Federal Budget moved into deficit for several years.

Risks in global fixed interest portfolios 47

Source: Citibank, The Yield Book.

Figure 3.2 Government borrowing in Australia (real borrowing in US$ bn (June 2003 base))

Jan-85 Jul-85 Jan-86 Jul-86 Jan-87 Jul-87 Jan-88 Jul-88 Jan-89 Jul-89 Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Jan-94 Jul-94 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jull-01 Jan-02 Jul-02 Jan-03

90 80 70 60 50 40 30 20

The trend among the English-speaking nations has been to reduce government debt, but within continental Europe and Japan, government borrowings have been on the rise (see Figure 3.3). The net effect is that government debt has remained roughly stable (in real US dollar terms) over the last decade.

Recently, budget deficits, while not quite fashionable, are certainly more common. Japan is running a budget deficit of over 7 per cent, France and Germany near 4 per cent and the USA approaching 5 per cent of GDP. It is likely that global government debt will increase over the next few years.

In Australia, Commonwealth Treasury estimates have the budget moving back into a structural deficit over the next decade due to demographic changes (assuming taxes are held as a constant proportion of GDP). This will occur even in the absence of reduced economic growth. It is likely that the Australian government debt market is at a cyclical low rather than at the end of its lifespan.

While government debt has waned then waxed over the last decade, corporate bonds issues have been steadily increasing, particularly over the last few years (see Figure 3.4). The vast majority of the growth in the corporate market has been in US dollar-denominated bonds. Corporate bonds denominated in euros comprise the second largest portion of the market, with sterling and yen bonds representing only 2.6 and 0.7 per cent of the market respectively.

9000 8000 7000 6000 5000 4000 3000 2000 1000 0

Japanese govt EDR Govt UK Govt Aust Govt US Govt

Source: Citibank.

Figure 3.3 Government debt market capitalization (real borrowing in US$

bn (June 2003 base))

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