Investor/An insider's guide to the market: One of the more significant developments in financial markets over the past year was the issue by several European treasuries of government bonds with maturities of 50 years. Investor demand for these ultra-long fixed interest securities has been growing in recent years.
The strongest appetite for these bonds has come from the trustees and managers of defined-benefit pension schemes. Companies that offer such schemes to their employees typically guarantee to pay pensions to their employees equivalent to two-thirds of final salary.
The costs of meeting these pension promises have escalated for two reasons. First, bond yields at historical lows means that a much larger pool of assets has to be built up to purchase these salary-linked pensions. Second, actuaries are busy reworking their pension cost calculations to take account of the fact that people in the developed world are living much longer than earlier generations.
In actuarial jargon, the liability profile of pension schemes is getting longer and consequently, trustees are being forced to invest in longer dated securities to more closely match their liabilities. UK pension funds have been particularly hard hit and heavy demand for long-dated securities has pushed up the prices of the limited supply of such bonds. Higher bond prices mean the yield offered to investors declines.
Across the Atlantic, the US treasury has not yet followed the Europeans with a 50-year issue, although last week it issued the first 30-year bond in four years. The size of the issue was $14 billion (€11.8 billion) and the treasury took in bids worth 2.05 times the amount on offer. The new 2036 bond was sold at a yield of 4.53 per cent.
The US yield curve is now slightly inverted, ie yields on long-dated bonds are lower than those on shorter maturities. An inverted curve is often interpreted as signalling an impending economic recession.
But there is as yet very little sign of an impending slowdown in the US economy, not to mention a recession. In the UK, which also has an inverted yield curve, the progress of the economy in 2005 was a little closer to textbook expectations. Higher short-term interest rates did generate a slowdown in the housing market and in consumer spending. However, more recent data indicate that the housing market has stabilised and consumer spending may be about to recover.
It is probably the case that the degree of inversion in the US and the UK yield curves is too small to warrant predictions of impending recessions. Also, part of the reason for the inverted yield curves is the exceptional demand for very long-dated bonds. Such demand, by driving up bond prices, is artificially depressing their yields. Therefore, the more correct interpretation of the US and UK yield curves may be that short-term interest rates are appropriate for this stage of the economic cycle, but long-term yields are artificially low due to an excess demand situation that will ultimately prove to be temporary.
