Benstead on Bonds: gilts and the pension time bomb

Investing in UK government bonds (gilts) is meant to be a safe bet – you lend money to the government, picking up coupons every six months and getting your money back (called the principal) when the gilt matures.

But there’s a catch – gilt prices can fall during this journey. This is all well and good if holding a direct gilt to maturity, as the price will return to its £100 redemption value. However, those investors holding gilts via a fund (which never matures and keeps adding new gilts as others redeem), or own a gilt that probably won’t be held to maturity (such as a 30-year gilt), are at the mercy of the market.

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One long-run force that undermines the case for gilts is the changing nature of the UK pensions landscape.

The area of concern for gilt investors is the under-way transition from Defined Benefit (DB) to Defined Contribution (DC) schemes.

Once common in the private sector but now largely reserved for state sector workers, DB pensions guarantee an income in retirement, meaning that pension funds know what their liabilities are. Gilts are therefore the bedrock of portfolios as they provide a fixed return (that can be linked to inflation) that can be used to match liabilities. 

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On the other, hand DC schemes have no such obligations, and are built to grow over a lifetime of contributions. Gilts feature, but equities are by far the most important asset in DC schemes.

The Office for Budget Responsibility (OBR) estimates that DB schemes’ holdings of gilts will fall from current levels of 26.7% of UK GDP to 5.6% of GDP in the early 2070s, by which point schemes which are today closed to new members will have almost entirely wound down their assets.

DC schemes will not offset this decline. The OBR finds that DC schemes’ holdings of gilts will likely rise from 2.8% of GDP in 2024-25 to 5.3% of GDP by the early 2070s.

“The rise in DC gilt holdings therefore offsets only around 12% of the fall in DB holdings, leaving total pension gilt holdings in the early 2070s at just over a third of their current levels as a share of GDP,” the OBR said.

The story therefore is that the gilt market is going to lose one of its key buyers. Less demand means lower prices, lower prices mean higher yields. Higher yields mean capital losses for gilt holders and higher debt costs for the government - but also a higher income for new investors.

The OBR adds: “Despite the growth in aggregate demand for assets due to an ageing population, our analysis suggests that the UK pension sector’s gilt holdings are likely to decline significantly over the next 50 years as a result of the ongoing transition from DB to DC schemes.”

To attract more gilt buys, yields would have to rise. This is because investors outside DB pension schemes are not forced by regulation to own gilts – their demand is more elastic and based on yields around the world.

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• Everything you need to know about investing in gilts

The OBR explains: “DB pension schemes have made up a stable base of bond demand regardless of yields, as their investments need to match their UK sterling index-linked liabilities, and they are governed by regulation. Other holders are likely, on average, to need more of a yield inducement to raise their demand, because they generally have a wider choice of safe assets to select from.”

It calculates that lower demand from pension funds for gilts will increase the overall interest rate on UK government debt by around 0.8 percentage points.

In current prices, and at today’s level of GDP, that would eventually result in an increase in annual debt interest costs of around £22 billion, according to the OBR.

So, more than £20 billion in additional debt costs for the government and yields 0.8 points higher, all due to set-in-stone changes to the UK pensions landscape.

But it may not be all doom and gloom for gilts as the OBR says that a number of factors may reduce this number. For example, the pension changes may already be reflected in gilt prices, which would imply a more muted reaction as demand for gilts by DB schemes dry up.

Gilt yields are certainly high compared with other developed-world government bond yields.

The 10-year gilt pays 4.64% and the 30-year is at 5.47%. This compares with 4.84% and 4.95% in the US. German and French yields are lower still - around 3% for the German 10-year and 30-year, and 3.3% and 4.1% for the French 10-year and 30-year.

However, the OBR analysis assumes that UK public sector net debt remains at current levels of almost 100% of GDP. If, however, public debt rises as a share of GDP, all other things being equal, this would place more upward pressure on gilt yields. And it looks very likely that debt will keep growing, with an ageing population, failed attempts from the Labour government to cut welfare spending, and a struggling economy.

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Peter Spiller, manager of the defensive Capital Gearing Ord (LSE:CGT) investment trust, says: “We have written about the risks of elevated government debt and unsustainable fiscal policies for some time.

“The UK’s public finances are widely acknowledged to be reaching this situation, alongside other developed markets such as the US, France and Japan. Our initial view was that the UK needed fiscal reform to avoid a debt crisis. After the events of the past weeks, our revised view is that the UK will not see fiscal reform until there is a crisis.”

While the longer-term outlook may look bleak for gilts, there could be shorter-term opportunities.

Gilts – particularly longer ones with a higher duration – should respond well to lower inflation and interest rates. A recession could therefore spark a big rally in gilt prices, causing yields to fall.

One gilt that could really jump in this environment would be UNITED KINGDOM 0.5 22/10/2061 (LSE:TG61), which matures in 2061 and has a 0.5% coupon. Between 2022 and mid-2025, demand for this gilt has grown significantly. The most notable growth came in 2024, which saw net inflows more than triple compared with 2023.

So, while longer duration gilts may be considered by some as risky long-term investments due to pension changes and UK fiscal challenges, they can still act as a useful hedge against a recession in the UK, providing capital growth during a period when stock markets may be falling.