October 2016 Credit Management magazine

FEATURE
SPECIAL
is a mutual scheme covering about 6,000
defined benefit funds. According to the PPF,
in 2015, a 0.1pp fall in gilt yields would have
raised members’ liabilities four times more
than it would have raised the value of their
assets.
The combined deficit for PPF member
schemes in Q1 2016, before the Brexit vote,
had already reached almost £300 billion,
close to the sum of gross profits for all UK
non-financial corporations in the past year.
Just after the Brexit vote at end-June, the
deficit had almost hit £400 billion, as a result
of further falls in UK government bond yields.
Indeed, for all UK pension schemes, including
those covered by the PPF, the deficit is
approaching £1 trillion as a result of falls in
bond yields. To put that in perspective, the
BHS and British Steel pension fund deficits
are together just 0.1 percent of that £1 trillion.
For their part, life insurers should not
be underestimated in significance: they
hold 10 percent of all assets held by UK
financial institutions; and the IMF devoted
a whole chapter to the sector in its Global
Financial Stability Report in April. The new
EU regulatory regime for insurers, Solvency
II, requires them to report their economic
capital and discount assets and liabilities by
current interest rates. Moreover, it imposes an
extra capital buffer on insurers that deepens
as risk-free rates fall. Accordingly, the Bank
of England hinted it would allow insurers to
phase in Solvency II more slowly after its
0.25pp rate cut in August.
UK TREASURY
Turning to the government, a one pp increase
in average funding costs would impose
additional costs of about 0.9 percent of
GDP on the government, which would have
to come from austerity, tax rises or more
debt issuance. However, that would be an
extreme scenario as the UK government debt
has one of the longest average maturities
in the world, and the Treasury only needs
to refinance about one-tenth of the national
debt each year. So in practice, a one pp rise
in refinancing costs might only impose a 0.09
percent of GDP hit. The downside of this is
the Treasury cannot benefit as much from
falling bond yields.
BONDHOLDERS
For gilt investors, and bondholders in general,
the fear is of interest rate rises. For a portfolio
of UK government bonds, weighted the same
in maturity terms as the overall stock of UK
government conventional debt, just a one
pp rise in yields across all maturities would
visit an approximate 10 percent loss. The
loss would range up to an 18 percent drop in
value for a gilt maturing in 2046. The lack of
high-quality debt since the crisis has caused
investors to crowd into safe bonds and an
interest rate shock would have enormous
impacts on the value of bond-holdings (the
face value of central government-issued debt
outstanding was at least £20 trillion at end-
2015). However, low interest rates also reduce
investment income for many bondholders, as
maturing investments and coupons have to be
reinvested at lower rates.
SUMMARY CONCLUSIONS
Looking at the winners and losers from the
scenarios of interest rate normalisation and
further policy easing, these are just firstorder,
obvious impacts, but they already add
up to a difficult calculus for policymakers.
Broadly, if rates are lower for longer, savers,
insurers and pension funds and future pension
beneficiaries get hit, while bondholders, the
government and borrowers get shielded. The
worst-case scenario is that negative and ultralow
interest rates are prolonged and it is future
pension fund beneficiaries who, after lifetimes
of work, see their claims devalued and used to
bail out post-Brexit Britain and UK plc.
The recognised standard
www.cicm.com October 2016 23