Expert View: Falling British bond yields: a tale of the unexpected

Given the inflationary pressures, the decline is truly remarkable
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The Independent Online

Consider the following facts: the UK government will borrow £37.2bn this year; an upward trend in public sector pay was underlined last week as university lecturers threatened not to mark exams to back up a pay claim; the US consumer and the US government continue to borrow hugely; and oil prices are at record levels.

This should all be very bad news for bond markets, and US bond yields have indeed been rising recently (which means falling prices). But on a two-year view, it is more notable that UK bond yields have fallen markedly since 2004. The average yield on 10-year corporate bonds this year is 4.8 per cent, against 5.8 per cent two years ago. This comes late in the economic cycle - two years after the US Federal Reserve started tightening policy.

The American economy has enjoyed sustained growth since 2002. This year, the long-delayed recovery of the Japanese economy and continuing strong growth in China and India have contributed to an upsurge in oil and other commodity prices. Given these potentially inflationary late-cycle pressures, the continuing fall in UK bond yields is truly remarkable.

There was a much larger decline in corporate bond yields from 6.8 per cent in January 2000 to 4.6 per cent in mid 2003, but that was unsurprising. The world economy went into recession in 2001 and recessions are usually good for bonds. Oil prices were around £30 a barrel, less than half today's levels. The dot-com boom had ended and investors escaping from risky equities moved into bonds, driving prices up and yields down.

But what can explain the more recent steady downward trend in corporate bond and gilt yields?

One common explanation is that pension funds have been buying gilts following legislation that obliges them to reduce their deficits.

The emergence of large deficits under the new FRS17 accounting standard has also caused pension funds, it is said, to rebalance their asset portfolios. They have sold equities and bought bonds to reduce the risk of these deficits recurring.

Because pension fund liabilities are measured by discounting future expected pension payments at an AA-grade corporate bond rate of interest, the fall in bond yields would, other things being equal, make pension deficits worse. It is for this reason that pension funds are sometimes accused of making a rod for their own backs by switching into bonds.

Some argue that the desire to stabilise pension fund deficits by reducing the exposure to equities has resulted in higher deficits, as bond purchases have driven yields, and hence the relevant discount rate for liabilities, downwards.

However, the evidence for such a causal link is weak. There is nothing particularly new about British pension funds shifting into bonds. It is a natural consequence of an ageing population. Even if there has been an acceleration in this shift (possible, but by no means certain), the effect on global bond markets would be negligible.

The main influence on bond markets over the past 15 years has been the remorseless reduction in inflation and in inflationary expectations.

The worldwide shift to independent central banks has been one cause of this. The continuing fall in the price of manufactured goods from the newly industrialised countries (notably, but not exclusively, China) has been another. The downward pressure on wages in the main industrialised countries as a result of immigration (from the south in the US and from the east in Europe) is a third cause.

These are powerful forces. Just how powerful is revealed by the continuing fall in bond yields at a point in the economic cycle when they would normally be expected to rise.

The behaviour of the pension funds, although it may reinforce the decline in yields, is really only a sideshow.

Bill Robinson is director of economics at PricewaterhouseCoopers