01 Oct 2010 | Capital Hill

Capital Hill on... Bond Yields 

Jennifer Hill discusses bond yields and how they affect the wider market.

Government bond yields have hit record lows. If you don’t hold gilts in your portfolio, you might be forgiven for thinking it’s of no consequence to you. You could be mistaken.

Gilt yields not only reflect the economic outlook, but also have an impact on everything from pension fund valuations to annuity rates. Let’s take a look. The most important thing to understand is that prices move inversely to yields. So, if gilt prices fall, yields rise and vice versa. Of late, prices have been rising, sending yields sliding.

Investors have sought shelter in the relatively low-risk asset class amid fears over a double-dip recession and the economic impact of the new coalition government’s austerity measures.

Rising demand has sent prices up and yields on benchmark 10-year gilts have fallen from above 4.2% in February to just below 3% at the end of August.

So, what does this mean for investors? Well, by and large, falling yields are a good thing for those already invested in the asset class.

Say you had bought gilts issued some time ago with a yield (also known as the ‘coupon’) of 5%. Gilts are always issued in units of £100 each, so the 5% coupon means you receive £5 in interest each year.

Your effective return remains the same today. The only thing that has happened is that the yield is expressed as a lower percentage as the capital value of your holding has risen.

If you keep the holding to maturity, you’ll get your £100-per-unit back. However, you could sell the gilts through the stock market – and make a tidy profit.

Conversely, those who buy in at the top of the market – and some commentators, such as Roger Bootle, managing director of Capital Economics, believe gilt yields are “probably getting close to their floor” – could rack up big capital losses.

Onto pensions now, and falling yields are, again, bad news. Lower gilt yields increase defined-benefit pension fund liabilities: these soared to a record high of £1.2 trillion in August, according to Aon Consulting.

That figure is 20% higher than a year ago – a direct result of falling yields, which are used as a benchmark for assessing future pension liabilities.

This creates a vicious circle: falling bond yields increase pension fund liabilities, so pension fund trustees become ever more desperate to match their assets to their liabilities – by buying more long-dated gilts. This demand stokes prices and depresses yields still further, increasing net liabilities again.

And the bad news continues for those nearing retirement. Annuity rates are also priced according to long-dated gilt yields.

They have hit an all-time low. The average level annuity for a 65-year-old man has tumbled 6.3% since last August, while the female equivalent has dropped 5.6%, Moneyfacts data shows.

There is one big winner, though: the government. Lower bond yields reduce the cost of financing the government’s new borrowing and of refinancing its maturing debt. For everyone else, as long as the economic downturn continues, so does the gloom for those of us in the UK.

The views that are expressed in this article should not be taken as fact and no reliance should be placed upon these when making investment decisions. They should not be considered as advice or a recommendation to buy, sell or hold a particular investment.

This article contains information and opinion on investments that does not constitute independent investment research and is, therefore, not subject to the protections afforded to independent research.

Author: Jennifer Hill
Jennifer is an award-winning British financial journalist. She recently left The Sunday Times, where she was deputy Money editor, to set up her own company, Media Hill Ltd. She is a previous personal finance correspondent of Reuters, the global news service, and personal finance editor of The Scotsman newspaper.

She has won or been shortlisted for six Headlinemoney awards, the ‘Oscars’ of personal finance journalism in the UK. She has also scooped or been nominated for accolades from the Association of Investment Companies, Ignis Asset Management, the Association of British Insurers and the British Insurance Brokers’ Association.