Gilts bubble could burst overnight, warns study

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The Independent Online

The surge in UK government bonds prices that saw yields collapse to historic lows is an unsustainable bubble that could collapse "overnight", a leading analyst warned yesterday.

Tim Bond, head of global asset allocation at Barclays Capital, said the price of long-dated gilts was 136 per cent higher than its long-term average.

He said that new pensions regulations - which forced funds to buy more bonds when yields fell, driving prices up and yields down - had created a "classic example of a bubble".

He compared it to the high-tech boom when index-tracking investment funds were forced to buy into the market to keep up with the speculative surge in prices. He warned: "It could deflate very rapidly as it would just take a couple of statements by the pensions regulator that could cause a very quick move. It could come overnight from a change in the regulatory approach. It is a very unstable and brittle situation".

He said defined benefit pensions funds - those most affected by the fall in yields - amounted to £800bn, while the current stock of long-dated index-linked gilts totalled just £41bn. "It is like trying to squeeze an 800lb elephant into a 41lb sized Mini because there are not enough assets available," he said.

The gilt markets were sent into turmoil last month when yields on the new 50-year index-linked gilt tumbled to an historic low of 0.36 per cent.

The fall was blamed on new rules - designed to prevent pensions failures - ensuring pension funds measured deficits using long-dated gilt yields.

The Debt Management Office, an arm of the Treasury, held a meeting with fund managers and market makers and auctioned a fresh batch of long-dated gilts. Further issuance is expected in next month's Budget.

Mr Bond said the Government could issue more gilts but that a longer-term solution would be to change the way deficits were measured. He said using long-dated gilts did not reflect the fact companies often borrowed to make risky investments that would deliver higher returns.

He said stronger companies should be able to use a discount rate that reflected their ability to invest in higher risk assets and benefit from diversification.

He added that pensions right and liabilities could be made freely tradable to allow the markets, rather than accountants or regulators, to assess the viability of schemes.

Paul Tucker, an executive director at the Bank of England, said companies were diverting cash away from investment to fill their pension fund deficits.