Winners and losers from the great bond market crash of 2013

Allister Heath

DON’T say you weren’t warned. The great bond market crash is upon us and it has further to go. The cost at which the US, UK and some other governments can borrow is shooting up, with the 10-year gilt and the 10-year Treasury bond both breaching the symbolic 3 per cent yesterday. Mark Carney and the monetary policy committee are not hiking interest rates – but the markets are doing the work for them.

Forward guidance – the new tool used by the Bank of England – is failing. It was meant to keep borrowing costs low, including gilt yields, but the markets simply do not believe that the resurgent economy is compatible with three more years of ultra-low rates.

They are also trying to test the Bank and Carney: how high do gilt yields have to go before the governor decides to step in with more quantitative easing (QE)? And how would people react to such stimulus if it coincided with strong economic growth?

Ten year gilt yields are up by 63 per cent year to date. Five-year gilt yields, which matter especially for the mortgage market, were 0.609 per cent on 5 April – now they are at over 1.7 per cent. The rapidity of this increase has inflicted massive losses on bond investors. One of the losers of the bond crash has been the Bank of England – which owns £375bn worth as a result of its policy of quantitative easing (QE).

There are a number of reasons for the rise in bond yields. The first is that the economy is improving and faster growth implies a greater demand for investable funds, and hence higher interest rates. Strong economies tend to push up the price of money; weak ones to reduce it. If the economy continues to recover, markets will also begin to increase their inflation risk premium, which is one important component of gilt yields.

Quantitative easing also pushed down yields artificially by bolstering the demand for government bonds and freeing the private sector, for a while, from having to supply as many funds to the state; the fact that QE is now on hold and the economy improving, suggesting no more extraordinary measures, is another important reason for the increased gilt yields.

Higher yields will make it harder for the government to borrow, and will also push up the cost of corporate and private sector borrowing, which is benchmarked at least loosely on the “risk-free” interest rates paid by the government. The coalition is desperately seeking to subsidise mortgages – yet their cost will now rise. That is the reason why the Bank was so keen not to see such hikes in the cost of credit, and why the market reaction to the good economic news will eventually begin to slow the recovery down.

But it will also boost some firms. As M&G’s retail bond team pointed out yesterday, the higher gilt yields, combined with rises in the equity markets, will reduce or even eliminate entirely the deficits of Britain’s defined benefit pension funds (because higher yields mean a higher discount rate, which reduces the net present value of future pension payments). The economy-wide defined benefit pension fund deficit was £317bn in May 2012 and £115bn by July 2013 – and it will be much, much lower when the next figures are released.

The need for older companies – often in manufacturing– saddled with old-fashioned pension commitments to find so much cash has been one of the reasons corporate investment was so limited in recent years. There was no money left to spend on factories or offices; it had to go on pension obligations instead. This is no longer true.

Higher rates and bond yields are a good thing. Risk and the cost of money is being priced more correctly, as are pension pots. The real question, however, is what will the Bank of England do if all of this continues?
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