The increase in pension funds investing in government bonds is expected to push up the price of long...
The increase in pension funds investing in government bonds is expected to push up the price of long-dated bonds in the UK, Europe and US, and managers have been repositioning portfolios as a result of this.
The Schroders Global Bond fund is overweight on the long end and underweight on the short end for the UK, US and European markets.
David Scammell, director of fixed income at Schroders, is favouring the UK because interest rates, currently set at 4.5%, are expected to reduce this year.
He says: "The Bank of England has undergone its period of tightening and as consumer spending slows down, interest rates could drop. Inflation is falling and the Consumer Price Index figures show a fall to 2% in December from 2.1% in November. Also, a lot of pension money has gone into buying long-dated bonds, which has also increased the price and created demand."
The UK short-dated two-year gilt is presently yielding 4.2% compared to the 30-year, which is 3.71%. Scammell explains as interest rates are expected to fall, the price of the long-dated bonds will increase. However, Gareth Isaac, fixed income fund manager at Axa Investment Management, warns the bond markets have gone into overdrive on the long end in the UK and he does not think it offers good value. Axa's International Global Bond fund is presently underweight long-dated UK gilts.
Isaac says: "UK Government regulations now require pension funds to match their liabilities by investing in safer asset classes such as bonds. However, the problem is that the Government has not been issuing enough to cover demand so this has driven up the price to levels that are too high already."
He points out as the price of the bond is already high, he does not see their will be much gain if interest rates fall.
Rather, Isaac is overweight on the long end in the US and Europe because pension funds have only just started to invest in long-dated bonds in these regions. He does not expect the same supply and demand problems for the US or Europe as the governments in both regions are matching demand with extra supply.
Schroders has also decided to overweight the long end in the US and Europe. For the US, the two-year bond is yielding 4.33% and the 30-year bond 4.55%. Although the short-dated bonds yield is lower, Scammell believes their could still be one more rate rise in the US that would increase the yield on the two-year bond making its price fall. The Schroders Global Bond fund is neutral in the short end for this reason.
Similarly, Schroders is underweight European bonds in the two to five-year range, because of the possibility of a rate hike by the European Central Bank (ECB). The two-year German bond is yielding 2.8% and the five-year is 3%, compared to the 10-year at 3.26% and the 30-year at 3.5%. Last December, the ECB raised rates from 2% to 2.25% and this is expected to continue. Scammell also expects European long bonds to benefit from pensions funds placing more money into this asset class.
According to Standard Life, pension legislation in Europe, notably the Netherlands, is a structural support for the European bond market and this is likely to continue in 2006. Similar to the UK, many pension funds across the eurozone and Scandinavia are initiating asset liability matching switches, which are supporting long-dated bonds and index-linked bonds in particular.
Pension funds increasing the price of long bonds in UK, US and Europe
Interest rate cycle close to peaking in UK and US
Interest rates expected to rise in Europe
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress