COMMENT
The Bond Bubble

By Ed Bowsher (TMFArkle)
March 7, 2006

Six years ago, many investors were going barmy, paying inflated prices for technology companies. Now investors in UK government bonds -- known as gilts -- appear to be making the same mistake.

Just look at the figures for January's gilt auction. Investors were so keen to buy long term index-linked gilts, they bid up the price until the real yield was just 0.46%. That's an astonishingly low figure. Fourteen months earlier, the yield on similar gilts was 1.75%.

Why is this happening?

It's the result of the pensions crisis at UK plc. Many large UK companies have substantial deficits in their pension funds, and boards have been under pressure to close the gap between the funds' assets and liabilities. At the same time the usual method for calculating a fund's liabilities has changed.

Imagine that an actuary estimates that a fund will need to pay £2bn to pensioners between 2020 and 2040. The actuary then has to work out how much money should be in the fund today to meet those liabilities. In other words: what is the current cost of the future pension payouts?

Traditionally, a pension fund would be mostly invested in shares. So an actuary would look at a combination of share price growth rates and gilt yields. He could then work out the current value of the fund's liabilities.

However, new accounting standards in 2002 recommended that actuaries should only use gilt yields for these calculations. Gilt yields are normally lower than share price rises, so if an actuary only uses gilt yields for valuation purposes, the current value of a fund's liabilities instantly rises.

Given that gilt yields are now being used to calculate liabilities, the safe approach for pension trustees is to invest a large part of a fund's assets into gilts. This increases the demand for gilts, prices rise, and the yields fall further. Falling yields mean that the discount rate falls further and the present value of a fund's liabilities rise again.

Barclays Capital sums up the situation very well: "Such self-perpetuating, circular trends are the identifying characteristics of a bubble."

Does it matter?

Yes.

The biggest downside is that companies are obliged to pay more money into their pension funds than is necessary. That's money which could be invested in a company's growth. The lack of investment is bad news for shareholders and taxpayers. Even if you don't own any shares, we all need decent economic growth to pay for better hospitals and the like.

It's also very bad news if you're planning to buy an annuity in the near future. Annuity rates are based on long-term gilt yields, so low gilt yields mean low annuity payments.

On the plus side, the gilt bubble may explain why UK share prices still look relatively cheap. As I write, the FTSE-100 is trading on a price/earnings ratio of 13 compared to a ratio of 15 for the equivalent French index, the CAC. Pension funds have not been buying enough shares and that may be why UK shares are on a lower rating.

Now what?

I certainly have no desire to buy gilts at current prices. If your desire for security makes you determined to buy gilts, it might make sense to drip feed your cash into gilts over a longer period -- hopefully yields may rise in time.

As for companies, the best approach is to look for attractively priced companies which aren't weighed down by huge pension deficits. The team at The Motley Fool's Champion Shares service has found several stocks that fit the bill. Sign up for a guest pass and take a look.