Expert View: Bonds fare better in a bear market

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Pension fund trustees are re-examining the case for bonds, for three mutually reinforcing reasons. The first is this week's news that the Fed is concerned about deflation, and fixed income securities do well when prices fall. The second is the change in the accounting rules, which have until now inhibited any movement into bonds. The third is the three-year slide in equities.

The bear market has reminded us that it is risky to fund pensions, which are relatively predictable obligations, with equities, which provide a highly uncertain income stream. For the first half of the last century most pension funds were fully invested in bonds - the Church Commissioners held bonds to pay the stipends of clergymen. That policy was discredited as creeping inflation eroded the value of interest payments and higher interest rates destroyed the capital value of bonds. So from the 1950s pensions policy changed. Equities gradually replaced bonds because they offered a growing income stream and provided some protection against inflation.

The "cult of the equity" was reinforced by the accounting rules. The old rules reflected the reality that equities can be expected to outperform bonds in the long term. But they did not recognise the additional risks attached to equities, which were concealed by infrequent valuations of the portfolio and considerable actuarial discretion in arriving at those valuations - in particular the ability to value pension fund liabilities at a lower figure as the equity assets fell in value.

The new rules, by contrast, make clear the risks of equity investment. Equity portfolios will be marked to market on an annual basis. Pension fund deficits will, under the new rules, look larger (because liabilities will be discounted at the lower bond rate of interest) and be more variable (because of the annual valuation). Whether these changes are already priced into the market price of companies with large pension schemes remains to be seen.

The new standard comes into effect in 2005, but it is already influencing pensions policy because the new figures appear in the notes to company accounts. So trustees must now manage funds with an eye on these figures. The brutal fact, underlined by the deficits emerging from a three-year bear market, is that the more a pension fund invests in equities, the greater are the chances of insolvency. That is why the credit ratings agencies are now taking pension funds into account when they assess the creditworthiness of companies.

Under the new rules,increased bond weighting becomes more attractive for pension fund trustees. Index linked bonds, unavailable when the cult of the equity began, offer an inflation-proofed alternative. Conventional bonds, paying a fixed income, have become attractive as central banks around the world have delivered low inflation, though rising government deficits pose a new risk. The possibility of deflation (less likely in Britain than in Japan or Germany) increases their attractions.

But trustees will not be quick to change their strategy, and even if they do bond prices won't necessarily rise. Switching from equities into bonds is risky because the stock market could stage a rapid recovery. That is why those thinking of a switch will consider making a countervailing switch in the company. Clever hedging deals of this sort could become the conventional wisdom in the new low-inflation environment, making bonds the favoured financing vehicle for companies, as well as the favoured investment vehicle for pension funds. So the increased demand for bonds will call forth an increased supply rather than drive up the price.