1 November 2018
US government bond yields have risen Yields on 10 year government bonds from the US rose above 3% pa at the middle of May, for the first time since 2014.
I wonder at what point would UK pension schemes consider US government bonds as an alternative to their lower yielding UK equivalents? Have we reached it?
The case for US government bonds
I think there are three good reasons why UK pension schemes might want to consider a position in US government bonds: the return, the liability matching characteristics and the diversification benefit.
US government bonds are offering nearly double the yield of UK gilts. They are now one of the highest yielding, developed government bond markets as shown in the chart below.
With many UK pension schemes de-risking and no longer requiring high returns to meet all the pensions promised, a 3% pa return would be a significant contribution to the overall return they need.
With the backing of the US government, they are of course virtually free of any credit risk.
US government bonds and UK gilts also have a reasonably high correlation and the price tends to react in a similar way to economic news. After all, it’s a global economy so the factors causing price changes have a similar effect on all developed bond markets. So while US government bonds don’t have the precision of UK gilts for matching the value of pension scheme liabilities, they offer some matching characteristics.
Furthermore, to the extent schemes require higher returns and need to maintain an allocation to riskier growth assets, US government bonds are often good protective assets and diversifiers. When global equity markets have gone through turbulent, negative periods, the US bond market has tended to rally. Some of these protective characteristics come from investing in US dollars, which also tend to do well when equities fall, boosting returns for a UK based investor.
While this sounds like an amazing opportunity – why wouldn’t you choose to have yields of 3% vs 1.5%? Of course, there’s a catch! Any gain that you get from the greater yield on US Treasuries might be wiped out by depreciation of the US dollar against the pound. If that did happen, on the plus side, it’d be cheap holidays in the US.
You could, of course, hedge this currency risk, but the total cost of hedging is about the same as the excess yield.
But could the unhedged dollar exposure act as a further boost to investment returns? Since the end of 2016 the dollar has depreciated by 7% against sterling. So there’s some protection that you’re already buying a depreciated dollar.
In my view, there must be a point when UK pension schemes would consider US government bonds as an alternative to (at least some of) their UK gilt holding. Is double the return at a 1.5% pa pick-up enough for everyone? I doubt it. But surely it must be attractive enough to consider a smaller allocation if and when a scheme is increasing its hedge ratio? And if adding some dollar exposure across your portfolio helps to reduce risk… then win-win!