Bonds yields rarely take centre stage in the reporting of financial markets. This week they have emerged from obscurity by hitting their lowest level for more than a decade. So what do these rock bottom yields mean for the average investor?
A close look reveals some unsettling consequences, and not just for active investors. Anyone with a pension, and most of those with an endowment savings plan, will be affected.
At first glance the figures seem innocuous enough. The 15-year variety of UK government gilts yesterday yielded 6.26 per cent - against 7.77 per cent a year ago, a fall of a mere 1.51 percentage points.
However, for anyone buying an annuity now, it makes a difference of thousands of pounds in annual income. Because annuities give a guaranteed income until death, they must be backed by fixed-interest products such as gilts. When gilt yields go down, the price of gilts is almost certainly going up, costing annuity providers substantially more to give the same level of income.
That cost is, of course, passed on. A 55-year-old man who paid an annuity provider pounds 250,000 yesterday would get an income of pounds 19,707 a year. The same sum a year ago would have bought pounds 22,793, according to figures form the Annuity Bureau, a specialist annuity adviser. In other words annuities are providing 14 per cent a year less in income because of the fall in bond yields. The rule of thumb is that for every fall of 1 percentage point in gilt yields, a pension saver needs 10 per cent more capital for the same retirement income.
Owners of endowment policies may also be concerned at low bond yields. The growth of endowment savings depends crucially on the bonus paid out by the life office which sells the endowment.
Actuaries, the life office gurus who decide how much the bonus should be, split it between an annual bonus, which is guaranteed to be paid, and a terminal bonus, which is not guaranteed and is only paid at maturity. The less actuaries expect from investments, such as bonds, the less they guarantee to pay.
Even the best-paying life offices are now promising just 8 per cent every year - and this will probably get lower. For investors who bought endowment mortgages in the hope of returns of 12 per cent a year, payments may well need an urgent review. That will avert a nasty surprise when the mortgage falls due.
The drop in bond yields is attributed by most observers not to current events but to long-term economic factors. The Government's decision to stand firm on meeting the Maastricht criteria for monetary union has led brokers to expect low long-term interest rates, which makes even a bond yield of 6.25 per cent attractive.
So ironically, Labour's European policy is doing much more to push up the cost of pensions than the Budget cuts in dividend tax relief.Reuse content