Implications of a Negative Policy Rate Environment for UK DB Schemes

Defined Benefit (DB) schemes in the United Kingdom (UK) continue to be buffeted by the economic fallout of the COVID-19 pandemic. The Purple Book provides the most comprehensive data available on private sector UK DB pension schemes: last year’s publication data, captured at the height of the first peak of COVID-19 in the UK, showed funding ratios had fallen from 99.2% to 94.9% year on year. The latest PPF 7800 Index data publication shows that whilst funding ratios have improved since then, they have yet to recover to pre-pandemic levels.

To understand this better, we modelled a conventional investment portfolio, made up of growth assets, represented by global and UK equities, and matching assets, represented by UK government bonds. Figure 1 shows the 2020 year-end returns for global equities, UK equities and UK nominal and inflation-linked bonds versus their returns as of end-March 2020.

As is evident, from the start of 2020 to March, return generating assets suffered dramatic losses, whilst UK nominal yields moved sharply lower. Since then, global equity prices have recovered, but UK equities continue to underperform due to the Brexit and pandemic-related uncertainties, and yields remain low.

Monetary Policy in the Current Economic Context

The policy direction of the Bank of England (BoE) has important implications for the UK’s DB schemes. It is therefore pertinent to note that the BoE’s Monetary Policy Committee (MPC) announced in its 2020 August Monetary Policy Report that negative bank rates would be added to the central bank’s policy toolkit. If the BoE were to indeed lower the bank rate below zero, the UK rates market would enter unchartered territory.

But negative policy rates aren’t a new phenomenon globally. The European Central Bank (ECB) has held policy rates negative from 2014 and the Bank of Japan (BoJ) from 2016 (Figure 2). We could therefore take comfort from the fact that other financial markets have continued to function with negative policy rates and expect the UK rates markets to be able to navigate through such an environment should the situation arise.

Negative Policy Rates and the Effective Lower Bound

The BoE’s discussion around negative policy rates is in the context of the lower effective bound (ELB), the rate at which further cuts in the policy rate would no longer provide stimulus to the economy. ELB levels differ across economies and over time. When policy rates reach their ELB, central banks typically turn to unconventional methods to provide monetary stimulus to their economies, including asset purchases of bonds, forward guidance on where policy rates would be in the future and establishment of credit lending facilities to boost lending in the economy.

The MPC identified the ELB for the UK economy on several previous occasions. For instance, in March 2009, the ELB was judged to be 0.5% and the BoE resisted lowering below this level. This was in large part due to the negative impact that may have on banks and building societies, which had income generating mortgages with payments linked to the base rate but liabilities in the form of deposit rates that could not be lowered below zero. In this context, lowering the base rate below the ELB was judged to potentially constrain financial institutions’ ability to lend.

The ELB was revisited in the June 2012 MPC meeting and the minutes revealed that the MPC judged the ELB remained at 0.5%. By 2016, however, the ELB was deemed to have fallen and was “close to, but a little above zero”. This allowed the base rate to be cut to 0.25% in the August 2016 MPC meeting as part of a package of measures introduced after the UK’s vote to leave the European Union.

The latest review into the UK’s ELB saw the BoE and the Prudential Regulation Authority (PRA) taking the additional step of requesting information from the CEO’s of PRA-regulated firms on their operational readiness for a zero or negative bank rate. The deadline for responses was early November 2020 and the BoE communicated the results in its February 2021 MPC meeting: firms would require an implementation period of no less than six months to make the required changes to their IT systems – any less could negatively impact some firms’ safety and soundness.

It is important to note that the structured engagement that took place in 2020 was “not asking firms to begin taking steps to ensure they are operationally ready to implement a negative Bank Rate”. The decision to ask firms to begin making those changes was taken in the February 2021 MPC meeting. However, the minutes emphasized that by doing so, the MPC was not intending to send any signal about the future direction of policy rates.

Whilst the MPC as a whole has yet to give guidance on its views on the ELB, external MPC member Silvana Tenreyro’s comments implied that the UK’s ELB has moved lower than zero, though she was careful to note operational feasibility was important . On the other hand, Governor Andrew Bailey and Deputy Governor Ben Broadbent suggested that such a move could harm the financial sector’s margins and restrict lending . These latter comments have dampened expectations from some market commentators on the use of negative policy rates as and when they become viable.

All in all, negative policy rates are set to become a feasible tool in the monetary policy toolkit in no less than six months. Whether they will be deployed as a policy tool will depend on the outlook for the economy and the merit of negative rates versus other tools available to the MPC at that point in time.

Implications of Negative Rates for DB Schemes

Real gilt yields have been negative in the UK for some time. The deterioration in economic outlook last year and the announcement that the MPC would be considering negative policy rates have pushed front-end nominal gilt yields also into negative territory (Figure 3). If the base rate were to become negative, more bond tenors may be dragged into negative territory, which has important implications for the value of pension schemes’ liabilities.

Changes in interest rates and inflation expectations are regarded as unrewarded risks and DB schemes may want to consider reviewing their liability hedging strategy in the context of a negative interest rate scenario. We continue to see clients turn to liability-driven investments (LDI) to hedge these unrewarded risks and stabilize their funding ratios.

Our Target Leverage Funds are a powerful range of pooled leveraged profile LDI and equity funds, which welcomed their first clients in Q4 2020. DB schemes could also consider the below strategies and changes to their LDI and cashflow driven investment (CDI) portfolios in this context:

Rotating into Longer Tenor Gilts

For DB schemes with shorter tenor gilts in their matching portfolio, trustees may want to consider rotating into longer tenor gilts with higher nominal yields to avoid paying the government for the privilege of lending to them. Schemes would need to consider the impact that such a move would have on their overall hedging portfolio versus their liability cashflows, as well as the additional risk this would entail.

The appeal of longer tenor gilts lies in their higher yields, greater capital efficiency and potential outperformance should negative policy rates lead to other investors extending tenors in search of yield.

Diversifying into Global Corporate Bonds

There is an increased interest toward cashflow driven investment (CDI) strategies as more schemes are becoming cashflow negative. Since UK schemes have sterling denominated liabilities, DB schemes tend to first look to the sterling corporate bond market. A negative interest rate environment could see increased competition for GBP corporate bonds as other investors move along the risk spectrum in search of higher yielding assets.

In this context, UK DB schemes could consider broadening out their exposure to global corporate bond markets. The good news is that the global corporate bond market dwarfs the GBP market in size and brings with it the benefits of diversification and greater liquidity. For each 5-year bucket, ranging from 0-5 years to 10-15 years, the market value and number of bonds in different sectors are all higher the global corporate bond market. In addition, the top-10 concentration is lower for the ex-GBP corporate bond market relative to the GBP corporate bond market (Figure 4).

Finally, there is the added benefit of potential yield enhancement, primarily in the 10-15 years bucket whereas yield levels are more similar in the 0-10 years bucket. However, the smaller size and higher concentration of the GBP universe still support an allocation to non-GBP corporates that will achieve similar or higher levels of yield while providing for a more diversified portfolio.

A fund range that leverages these advantages is State Street Global Advisors’s Buy and Maintain CDI fund range, which invests in high-quality GBP, EUR and USD investment-grade bonds and hedges the cross-currency risk out. Driven by our more than 30-year legacy in environmental, social and governance (ESG) investing, our commitment to ESG principles is reflected in the investment process of our CDI funds, which screens for UN Global Compact, Controversial Weapons and Swedish Ethical Council recommendations.

Assessing the Impact on Repos

Schemes with LDI portfolios using leveraged gilts will be familiar with repurchase agreements or repos – an instrument whereby one party sells gilt securities and agrees to repurchase them at a predefined price. These repos effectively act as short-term loans, the interest rate for which is termed as the repo rate. If the BoE were to move the bank rate below zero, these repo rates will likely turn negative too, as we have seen in European repo markets.

It is worthwhile to note that even with the base rate at 0.1%, money market yields of certain Euro Commercial Papers and Certificates of Deposit are currently in negative territory. Negative repo rates in the future would mean we get to the unusual but interesting scenario where schemes could effectively get paid to borrow money and use leverage in their matching portfolio, which could somewhat offset a lower yield.

Conclusion

Negative policy rates will become a feasible instrument for the MPC to use in the future. Whether they will be deployed or not will depend on the macroeconomic situation at that time and views amongst the MPC members regarding their cost versus benefit vis-à-vis other available tools. Based on recent speeches, there appears to be a split in opinion between external members versus internal members of the MPC regarding negative rates, with internal members being more cautious about their use in the UK.

As far as UK DB schemes are concerned, in a negative policy rate environment:

• They may want to review their existing LDI strategy to further increase hedging if practical to hedge unrewarded risks or to consider rotating from shorter to longer dated gilts to avoid paying to lend to the UK government.
• The search for yield may compel them to look beyond sterling credit into global corporate bond markets where there is the potential for greater diversification, liquidity and yield enhancement.
• For those with leveraged gilt based matching portfolios, negative repo rates could offset some of the lower yield as schemes would effectively be paid to borrow.