In Shakespeare's comedy A Midsummer Night's Dream, fairy queen Titania has magic drops placed in her eyes when she sleeps. On waking, she falls in love with the first thing she sees, which happens to be a man with the head of a donkey.
What would Shakespeare have said about the squeeze in the gilt market in early 2006? Like Titania, the UK pensions industry has been sleeping in a dreamland of actuarial accounting. Now it has woken up to the market-consistent valuation of its liabilities. But like Titania, the industry has fallen in love with the first thing it sees: a 50-year index-linked gilt with a real yield of 0.5%.
In many respects, this bond is a thing of beauty, and recently earned its creators at the UK's debt management office (DMO) plaudits for their cleverness. So how did it acquire the ears of a donkey? The answer is an object lesson in the slippery quality of markets, which like the ancient Greek creature Proteus, change shape when you get too close. The lesson begins several years ago, when the FRS17 accounting standard first appeared.
The most important users of accounts are those who invest in the shares or bonds issued by companies. With very large, bond-like promises being made to pension scheme members, these investors deserve to know what the balance sheet implication of such a promise is. And the cost today of promising to pay money in the future is the cost of debt, which is typically assumed to be an investment grade bond yield.
Unfortunately, a legacy of the pension industry's long slumber in actuarial dreamland is that the assets used to pay pension liabilities have been dominated by equities, whose high expected returns were used as a discount rate under the old system. Not only is the impact of the asset-liability mismatch on balance sheet volatility striking, but emergence of some £100 billion of deficits has triggered regulatory intervention.
Reducing balance sheet volatility - particularly unrewarded volatility - is a key responsibility of corporate finance directors and treasurers. Meanwhile, the effect of new UK pension regulations such as scheme funding and the clearance process goes deep into the boardroom. Unsurprisingly, the result is profound risk aversion when it comes to pension scheme funding, and no asset better suits such an appetite than the 50-year index-linked gilt.
However, the protean, reflexive quality of markets changes the debate. When accountants quite reasonably said that the market cost of long-term money should determine a pension liability, they did not consider that the thinly-traded long-term sterling market would become aware of its role as a valuation tool, and at a point when UK Plc was underfunded to the tune of £100 billion.
And so, Titania may have awoken from the dreams of a fairy queen, but the 50-year index-linked gilt was squeezed to the point of growing donkey's ears. After all, the mismatch of pension assets and liabilities may be unrewarded risk, but if the upfront cash required to remove the risk is so great that the rewarded risks of business investment cannot be taken, corporate finance becomes asinine. This may be fine Shakespearian comedy, but has it the makings of a tragedy?
Thankfully, there is no need for an unhappy ending to the tale. Firstly, following consultation with the UK Treasury, the DMO (whose remit is to minimise funding costs) is likely to substantially increase its issuance of long-dated gilts in the 2006/07 financial year. And other sovereign issuers, notably Agence France Tresor, have informally considered issuing long-dated sterling bonds, although no official plans exist.
More importantly, long-dated sterling yields may be a valuation tool for pension obligations, but this makes long-dated gilts more of a benchmark than a mandatory liability-matching asset. The UK Pensions Regulator has made it clear "trustees are not obliged to eliminate all risk", and that they "could allow for some degree of outperformance of scheme assets relative to bonds".
So long as pension schemes and their sponsors can manage risk of these assets intelligently, relative to their liability-driven benchmark, the Puckish behaviour of markets does not need to be a nightmare.
The week on Risk.net, December 2–8, 2016Receive this by email