A little over a month ago, the bond market buzz in the Eurozone was all about how widespread was the persistence of negative yields (where investors actually had to pay governments for the privilege of lending them money!) and whether the ECB would really be able to get its hands on all the bonds it has said it would buy in its Quantitative Easing programme.
Well, the ECB has commenced its bond buying programme, where it will inject 1.1 trillion euros into Eurozone bond markets, but despite this, in the past month, bond prices have fallen. This mean that those negative yields are less prevalent. In fact some of the moves we have seen in Eurozone bond yields have been very extreme. German 10 year bunds have given up 5% in value the space of two weeks as yields have moved from 0.05% to above 0.75%. Bond market forecasts have been for a move up in yields but certainly this burst of volatility and upwards surge in yields was not on the menu.
French 10 Year Bond Yields
If movements in bond yields were a soccer match, typically, they’d be the last one to be shown on Match of the Day. Bond markets used to be at the more boring end of the investment market spectrum. We are most likely at an inflection point in terms of global bond yields and while we may be confident about the direction, the past few weeks have shown the timing may be more challenging.
As we look forward, volatility in bond markets will be greater than what we have been used to in the past. There are fewer banks providing liquidity into the market, willing to make a price and act as market-makers, and at the same time the amount of money invested in bonds has soared. This compromised liquidity environment was doubtless part of the explanation of the “flash crash” we saw in US Treasuries in October last year. As we see, volatility in bond markets has spiked up again in recent weeks. Reasons advanced for this surge included interest rate policy changes, oil prices, inflation, politics, as well as the fact that many bonds were ridiculously lowly priced to begin with.
But bond yields play a very direct role for companies, their employees and investors - specifically in how they impact on the health of their defined benefit pension schemes. As is well documented, the overall health of defined benefit schemes has been deteriorating. At the end of the last decade this was due to savage falls in asset values as stock markets took a pounding but more recently despite the recovery in asset values, a rising liability profile has been the culprit. Companies have to use a discount rate to value the retirement benefits they have “promised”. This discount rate is reflective of long bond yields. Bond yields are by far the most important driver of these rising liabilities. As bond yields fall, the cost of these liabilities rise.
As many global companies announce their first quarter earnings the extent of this shortfall becomes apparent. Last week the German airline Lufthansa announced that its pension obligation doubled in the past year - to €10 billion! Companies such as BASF and Ericsson reported a similar scale of rising liabilities. Because overall bond yields have fallen so much, Lufthansa lowered the discount rate applied to its defined benefit pension scheme from 2.6% at the end of last year to 1.7% in this first quarter. This added about €3 billion on to their liabilities in three months. In Ireland, the Bank of Ireland pension combined scheme saw its deficit rise from €1bn to €1.7bn in the three months from December to March as bond yields went significantly lower. According to Standard & Poor’s, a 1% fall in these discount rates would on average cause a 16% increase in the obligations of the 50 largest European companies. So while bond yields have been declining around the world, and US and UK companies with DB schemes face the same problem, the absolute low levels of Eurozone bonds are a more pressing problem here. Clearly the ECB is playing a role here with its massive bond buying programme, and the deteriorating health of some pension schemes is something of an unintended (certainly unwanted!) consequence.
This is not just a pension accounting exercise. If companies are in the happy position of being able to inject extra assets into a fund to solve the problem it may nonetheless be being diverted from capital expenditure, debt reduction or dividends. If they can’t, the viability of the scheme from a regulatory point of view becomes an issue. Defined benefit schemes are closing and define contribution schemes are increasingly the order of the day, but for those in operation a weather eye on Eurozone bond yields is warranted.
Our investment view is that bond yields will drift up from here. For example, we simply can’t see any value in German 10 year bonds at levels of 0.05% where they traded on April 17. Eurozone bond yields may also be influenced, to a degree, by rising yields in the US as they approach a hike in interest rates. A gentle rise in Eurozone yields may provide some relief on the funding side assuming asset values aren’t compromised. However we feel it will be a slow ascent, topping out at lower levels than in previous cycles – meaning that yields by historical standards will still be very low. The ECB in its role as a buyer of bonds is another reason for the stuttering of the likely upward progress. Throw in the increased volatility that bond markets now seem to bring, and it’s clear that for members, trustees and sponsors of Defined Benefit schemes, funding concerns will stay pretty close to the top of the agenda.
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