"The Bear of Little Brain"

One of our cherished notions here at Newton over the past six years has been that there will always be a buyer of last resort to bail out the bond markets when the economics go against them for a while. We have been able to depend upon pension funds to step in and buy long-dated bonds at yields that make sense to an actuary, but not to an economist. This has helped stabilise markets in a way that not many people have appreciated, and has confounded a lot of the traditionalists who believe that the bond markets are just an extension of an economics text book.

This couldn't have been more true than here in the UK. Regardless of the state of the economic cycle, the indiscriminate buying of bonds has led to an inverted yield curve (which is usually seen as an indicator of impending recession), as demand from pension funds has outstripped supply provided by the UK government. By looking at the buying patterns of UK pension funds, things become much clearer (see first illustration). According to these numbers, pension funds have been putting money into long-dated gilts (and global bonds) at an increase rate since the dot.com bubble burst. Obviously, the UK government has spotted this and has been gradually increasing the amount of long-dated debt available in order to suit their captive audience.

However, the demand from pension funds in the UK gilt market isn't the whole story. In fact, the UK government appear to be issuing much more than is demanded by the pension fund market alone. If pension fund purchases are removed from the picture, it is possible to get a sense of just how much has been bought by agents other than the pension funds over the past few years (see second illustration). Although this graph is a little difficult to understand at first, what it represents is the amount of long-dated UK gilt issuance that was NOT bought by the pension funds. Surprisingly, between 2003-2005 there was a very large participation by agents outside the UK pension fund world. However, last year, all that changed. All but a small amount of the issuance was covered by just one group - the pension funds.

This dependency culture the UK gilt market now has on this group is very worrying, mainly because the case for including gilts in a portfolio has been severely weakened of late:

Rather than being an asset of choice, the justification for buying a 30-year bond that yields just 4.5% is becoming harder and harder. Add on top of this the need to control money supply, the housing market and some inflationary tendencies in the UK economy which should see base rates hit 6% before they are reversed, and it is evident why pension fund managers might be reluctant to support the auction process going forwards. In that case, UK bond yields are set to rise.

In this sense being underweight the UK gilt market is, as the saying goes, a 'no brainer'. The only caveat that we might have to put upon this is that all bond markets are still highly correlated with the U.S. Therefore, should a moderation of growth occurring there develop into an out and out recession requiring action by the U.S. Federal Reserve over the summer, UK gilt yields could be dragged lower in sympathy. Besides that, there is little case for holding long-dated bonds in the UK