Business Analysis: The 50-year bond returns but has it been worth the wait?

Long-dated gilts are no-brainer for the Chancellor but not such a safe bet for investors
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The Independent Online

What will you be doing on this date in 2055? Waving off the grandkids on their Easter holiday in space, perhaps. Heading to the pet shop for a new clone of your beloved feline companion of the past 50 years, maybe. Or simply hanging about waiting to be woken from a cryogenic freeze.

What will you be doing on this date in 2055? Waving off the grandkids on their Easter holiday in space, perhaps. Heading to the pet shop for a new clone of your beloved feline companion of the past 50 years, maybe. Or simply hanging about waiting to be woken from a cryogenic freeze.

Unpredictable, isn't it? Yet the Government is about to start selling 50-year gilts, bonds for which it promises to pay a fixed interest rate until their redemption in 2055. And the investment community is expected to bite its hand off when the debt is auctioned for the first time in May.

For the Government it is a no-brainer, locking billions of pounds of new debt at some of the lowest interest rates for a generation. For pension funds, crying out for ultra-long bonds, it will provide a predictable income with which to be more certain of meeting long-term pension liabilities.

But there is more than a sniff of worry that buyers of these bonds could lose a great deal of money.

Confirming the plan in Wednesday's Budget, Gordon Brown described the issue of a 50-year bond as a once-in-a-generation event, made possible "because we have entrenched stability for the longer term". Gilts, indeed all bonds, have grown in popularity along with the perception that inflation has been licked, thanks to non-political central banks acting independently to hit their ultra-low inflation targets. This expectation of price stability has given the financial markets more confidence in their predictions about our economic world in 2055.

The last government bond with a redemption date five decades out was issued almost five decades ago, before the inflation of the Seventies shattered previous confidence. The corporate sector and governments had commonly used 50-year bonds in the 1800s to finance the building of the railways or municipal projects, but there were just three government issues in the 20th century.

The first was the most high-profile, the Funding Loan and Victory Bonds of 1919, aimed at paying the bills from the Great War. This fund raising brought in the equivalent of £14bn in today's money, and its sale was launched at the City's Guildhall by the then Chancellor, Austen Chamberlain. Although the Prime Minister, Lloyd George, could not attend, he sent a message of support, saying that in buying the bonds you "get the premier security of the world" - comments that, when read out by the Chancellor, were received with wild cheers. In addition, a floral fete was held in Trafalgar Square.

Don't expect quite such a jamboree in May, but if France's recent experience is anything to go by, no great sales pitch will be necessary. In February, the French government issued €6bn (£4bn) in 50-year bonds, twice as much as it originally planned, and could have sold €13bn more to meet the total demand. The size of the first tranche of the UK's 50-year gilt issuance is subject to discussions with the financial community from next week, but is estimated to be at least £5bn.

Why is there such strong demand? "Since the collapse of Equitable Life, there has been regulatory pressure on insurers and pension funds to match their liabilities more closely, and as people are living longer and retiring earlier, these liabilities are lasting for longer," says Michael McKersie, the director of investor affairs at the Association of British Insurers.

The bear market in equities after the Millennium did not disprove the thesis that shares offer the best investment performance over the long run, but it did prove that shares can post some horrible losses in the short term. Pension funds are deciding to cut their exposure to the perceived risks of equities in favour of the predictable, ultra-safe cash flows from government securities.

So there is a shortage of ultra-long gilts with which insurers can match the liabilities of pensions and annuities bought by retirees - one of the reasons why annuities are more costly these days, giving a lower pension for a given lump sum. The situation is getting worse as the closures of defined-benefit pension schemes crystallise many liabilities that will become payable only when members retire in a few decades' time. Because of the shortage, the prices of bonds with far-distant maturities have stayed up in the UK, while they have ebbed and flowed more normally with changing economic assumptions in other countries.

John Ralfe - the independent pensions consultant who, while at Boots, moved the retailer's pension fund entirely into bonds - said the market is unlikely to be fussed whether the Government issues gilts with 50-year maturity or just more of the more traditional 35-year securities. "The question is whether the 50-year gilt is going to be more expensive, how much more expensive and whether fund managers are willing to pay up for it."

The trouble with the gilts rush is that pension funds may simply be throwing away money. The Government's last 50-year bond has paid 5.5 per cent annual interest to those who have held it since the beginning. A £100 investment in 1960 will have returned you £386, including the capital repayment, by the time it is finally redeemed in 2012. But the value of that cash has been whittled away by inflation and the real terms loss on the investment is a staggering 77 per cent.

The pensions industry will argue that a repeat of this disaster is unlikely in an era of low inflation, and in any case is not important as long as fund managers meet their monetary promises. But the most recent Barclays Equity-Gilt Study, which has analysed investment returns annually for the past 50 years, warned that buying gilts "represents risk reduction in the same way as bungee jumping without a bungee cord lowers risk: the outcome is certainly more predictable, but not necessarily more benign". The study included a graph, reproduced above, showing that real investment returns from gilts over a rolling 20-year period were as likely to be negative as positive, and argued that the risks of a negative return were higher over longer periods. Even a modest spike in inflation at one point over the next 50 years could wipe out much of the value of Mr Brown's new gilts.

The study's author, Tim Bond, head of fixed income at Barclays, said: "This is a fashion in investment consultancy, a fad more than anything else, and there is a huge inflation risk being taken here. Whichever way you slice and dice it, a 50-year gilt is not a good investment. The Chancellor may be getting a good deal for the taxpayer, but a proportion of taxpayers are pension investors so there is an element of robbing Peter to pay Paul."