Pension funds look to the long term with 50-year bonds

The second auction of 50-year gilts on July 14 was the latest in what could be a new trend for governments issuing ultra-long-dated bonds as a means of borrowing money.

France was the first to issue a euro-denominated 50-year bond in February. Since then BBB-rated Telecom Italia and the British government have followed suit with 50-year bond issues, and many developed countries including America, Germany and Japan are considering them. This September will see the launch of the first ever 50-year index-linked gilt.

But why have governments and organisations taken this step, and is there sufficient demand for 50-year bonds to have a significant effect on fixed income markets? Also, are there any attractions to these investments for retail investors?

Demand for the French issue was strong. According to Agence France Tr貯r (the department that issues French government bonds), the E6bn (4.2bn) issue was covered more than three times.

The bond has a coupon of 4% with a 4.21% yield at issue. More than a fifth (22%) of the issue was taken up by British investors, with hedge funds buying an 18% stake.

Telecom Italia managed to issue E850m of 50-year bonds with a 5.25% coupon. Given the long duration of the bond and the associated credit risk, many were surprised that the initial yield was only 106 basis points over the French government issue.

The two 50-year gilt issues in May and July amounted to 4.75bn, both with a 4.25% coupon. The initial auction was covered 1.6 times, but the most recent one only drew bids amounting to 1.23 times the issued debt.

From the issuer’s perspective it appears to be a “no-brainer”. If demand is there and given the currently low inflationary environment, being able to lock into low borrowing rates for 50 years makes sense.

Ian Robinson, head of credit strategy at F&C Asset Management, says: “For governments to be able to borrow for 50 years at 4.25% has to be attractive. You can’t be surprised that they want to sell, given the demand.”

With a number of developed nations having growing debt burdens, issuing cheap long-dated bonds is an effective way of managing deficits.

Insight Investment head of product management Chris Hartley says: “Demand is likely to be consistently strong. Fifty-year bonds have a strong application for pension funds, facilitating closer matching of assets to liabilities. If pension fund liability profiles go up to 50 years they are certainly useful.”

He adds: “As the pension industry becomes more aware of asset/ liability mismatching there will be a higher level of demand. It is likely that 50-year yields will remain below 30-year yields.”

But Robinson (pictured left) is less convinced: “There has been a shift, with investors buying long-dated bonds to match their liabilities, but is a 50-year conventional bond the best way to do that?”

He explains that liability profiles will often not stretch to 50 years, and the fact that redemption of capital is not due until the end of the period can lead to problems managing cashflows.

Even though life exp-ectancy is generally rising, the suitability of 50-year investments needs to be carefully considered.

“In some ways index-linked bonds are better for pension funds, given liabilities linked to wage and price inflation,” adds Robinson. He also questions whether pension funds should be buying long-dated bonds at such low yields.

Peter Day, fixed income portfolio manager at Barclays Global Investors, says: “There is an awful lot of supply coming into the market that will put pressure on the long end of the market. It is always a challenge to absorb large amounts of supply and a lot of active managers will be trying to anticipate shifts in the yield curve.”

Day explains: “Banks and hedge funds will be looking for opportunities to add alpha by trading the direction of yields and spotting anomalies in pricing between markets.”

Denis Gould, UK head of fixed income at Axa Investment Managers, says: “I don’t understand why there has been a jump from 30 to 50 years. Why not issue bonds with maturities of 35, 40 and 45 years? A lot of defined benefit pension schemes are closed and may have limited exposure to 50-year liabilities.”

But Gould (pictured below right) sees strong demand for the 50-year index-linked gilt: “It will get a very good reception because of its ability to guard against inflation. But a lot of demand may lead to very low yields,” he says.

Increased demand from institutional investors has led to lower yields for longer-duration bonds in the past. But Gould says further issuing of longer-dated bonds may lead the UK yield curve to adopt a more normal shape in future.

Future rises in interest rates and inflationary pressures could lead to the real value of 50-year conventional bonds eroding. The longer the duration of bonds, the higher the risk premium investors should demand for investing in them. This is even more important for long-term corporate bonds, where a company’s existence 50 years from now is certainly not a given.

Insight’s Hartley says: “The yield on a 50-year gilt is currently 4.3%, which is no higher than the yield on five-year bonds. For private investors who want steady income with no risk to capital, you have to argue for five-year bonds.”

But he expects a long-term trend of investors shifting assets from equities into bonds and up the fixed interest duration scale.

Jonathan Snow, a fixed income product analyst at Baring Asset Management, says: “I don’t think the volume of issuance will be big or quick enough to have more than a marginal influence on the yield curve.”

Undoubtedly supply and demand factors will determine the success rate of 50-year bonds, and there may be merit in investing modest amounts into them. But perhaps pension funds should consider not only the risks of mismatching liabilities, but also the risks of long-term exposure to a low-yielding asset class that may underperform other assets substantially over long periods.

For the retail investor it may just be a case of watch this space, although the introduction of 50-year bonds may offer opportunities for shrewd bond fund managers to exploit temporary price anomalies.