I’d rather be 50 than 30 (or is it the other way round)
My title, of course, refers to the 50-year maturity point of the conventional gilt curve rather than the 30-year. A preference for fifty years is certainly how the market's voting machine currently sees things. But how can changes in the longer end of the gilt curve impact LDI hedging strategies?
The following chart shows how the difference between 50-year yields is moving ever further into negative territory. In other words, investors are paying a increasing premium for 50-year gilts over 30-year gilts.
It seems unlikely that there are strong views around the evolution of the bank rate at these ultra long maturities. So there must be other factors at play. It's also not just a UK thing. Below we present the data in a different manner, splitting the yield curve into a series of one-year forward rates, and showing how the UK compares to the US and Europe. For example, 0.9% at 30 years represents the one-year GBP rate in 30 years' time.
Looking at the one-year forwards, perhaps the first reaction is that it can’t go down any further or put another way '30s50s' cannot go much lower. Of course, things are never that simple and indeed there are technical reasons why investors might pay a premium for holding 50-year over 30-year bonds.
Now, what’s in store from a supply (the Debt Management Office (DMO)) and demand (typically pension funds) perspective:
- Hedging is generally conducted in a pro rata slice across all maturities because things can always get more expensive. Hence, the inverted nature of the curve won’t be a barrier for buying here.
I’d rather be 50 than 30:
- These long maturity bonds are very capital efficient and require less repo (repurchase agreement) funding to get the same amount of interest rate sensitivity. We are in a benign repo climate at present, so if costs increase then that could be a driver for more 50-year investment (and less repo).
- As pension funds and long-term investors buy more into illiquid real assets this potentially address hedging at the longer maturities but a 50-year investment time horizon and credit risk can only really be filled by government bonds
I’d rather be 30 than 50:
- Demographic assumptions/reality is affecting pension fund liabilities. This should reduce 50-year liabilities and therefore demand.
- The DMO has listened to investors around the high demand for the ultra long part of the curve and announced on 23 March that a new gilt maturing between 2070 and 2073 will be issued in May.
When we combine that with the fundamentals (i.e. the exceptionally low forward rates relatively and in absolute terms) that points to a stronger case for 30s50s rebounding off the lows at some point but I wouldn’t bet the house (or all my 50-year bonds) on it.
For pension funds who have been overweight at 50-year tenors (often those who have used less or no leverage) then now is definitely the time to discuss whether that is still the right position.