Gilt trip turns into a curse for the little man

Britain's pension funds have a serious gilt complex and this obsession is taking the shine off these cast-iron investments for smaller investors.

Final salary occupational schemes are snapping up long-dated gilts, also known as government bonds, like a pack of hungry dogs that will only eat one brand of dog food. The recent auction of 50-year gilts only confirms the insatiable appetite - the £650m sale was almost twice oversubscribed.

The impact of the high demand for long-term gilts is that prices have spiralled and yields reduced, making the bonds an increasingly unattractive purchase for the ordinary investor and paradoxically for the pension funds themselves. Yet the pension firms keep on buying.

The reason price seems to be no object is that pension managers are under increasing pressure from the financial regulators to prove they can meet their future financial liabilities to scheme members. Those who cannot show this satisfactorily by the end of March will have to contribute more towards the Pension Protection Fund, a pot of money created to protect the incomes of members of final salary schemes that go bust.

The most secure method of showing they can meet their liabilities is to buy investments which match them. Long-dated gilts, particularly the index-linked variety, are about the only investment that enables them to do this. But the more the pension funds buy, the more the yield declines and the more long-dated gilts they need to buy to plug the gap in the required returns.

Philippa Gee, of investment adviser Torquil Clark, says doing this is a necessarily evil for pension funds: 'It is a vicious circle, but I can't see it changing.'

Gilts are issued by the government to fund public spending that is not met by other means, such as tax revenues. There are currently £255.5bn worth in issue. The gilts pay interest, called a coupon, to the investor, usually every six months, until a pre-agreed redemption date, which can be up to seven years hence (short-dated), between seven and 15 years (medium-dated) and more than 15 years (long-dated).

Gilts, like shares, can be traded at any time, but if they hold them to redemption, investors are also paid the face value of the gilt, normally £100. Investors like the safety aspects of gilts because the government is unlikely to go bust or default on the loan. They may be 'secure' but the price for this safety is unexceptional returns - particularly when they become popular, as long-term gilts have.

Almost all types of gilt are trading at more than face value. For example, Treasury 6 per cent maturing in 2028 was trading at £131.36 and the short-dated Treasury 4.75 per cent 2010 was trading at £102.10, which would mean a capital loss if an investor bought either of them now and held them to redemption.

However, the important sum relating to gilts is the redemption yield - or yield to maturity - not just the capital value. This shows the overall return from your investment, including income. Currently, redemption yields are about 4.2 per cent for short-dated gilts and between 3.8 and 4 per cent for longer-dated gilts.

Gee says: 'Gilts are not an investment class we are pushing at the moment. We would probably look at a gilt fund, such as HSBC's Gilt and Fixed Interest fund, instead. Recently it has returned 6 per cent a year, but there have been years with negligible returns.'

She says investors considering ultra-safe investments could also consider National Savings and Investments saving certificates, which are also backed by the government. The certificates are available only for short-term periods (two and five years) and pay a fixed 2.95 per cent a year net, but are tax-free.

Holders of long-term gilts could be tempted to cash in on the current craze by selling - following in the footsteps of certain investment managers. Short-term gilt investors may as well stick with it as the returns are not dissimilar to those from cash.

Alistair Mundy, manager of the Investec's Cautious Managed Fund, has recently offloaded the fund's long-dated index-linked gilts.'We are always on the look-out for investors acting irrationally and clearly we are seeing irrational investors at work in the bond market - in this case institutional investors,' he says. 'Life companies and pension funds are completing their switch out of equities into bonds at very low yield levels, which may be creating an exposure as risky as the high allocation of equities at the top of the equity market. They are acting like short-term investors.'

Mundy concedes that external pressures on pension fund managers are creating this distortion and producing herd-like behaviour - pressures that can only be relieved if the Debt Management Office, which is responsible for gilts, issues many more long-dated gilts. The demand for these gilts would also fall if accounting rules relating to the financial obligations of pension funds were to be changed.

Quentin Fitzsimmons, senior bond manager at Threadneedle, believes it is the politicians who have to rethink the current position. 'The DMO has other things to balance and it may disrupt the bond market if they simply issue more long-term gilts,' he says. 'People need to lobby their MP about pensions. Does the government really want to see defined benefits [final salary] schemes closing?' Fitzsimmons believes that today's pension deficit problems are still largely due to the withdrawal of Advance Corporation Tax in 1997, which removed a multi-billion benefit for pensions funds.

While future pensioners who have been following the gilt race might worry about their pension being adversely affected by managers ignoring potentially more rewarding investments, those retiring now and wanting to convert a proportion of their fund into an annuity are in more immediate danger.

Annuity rates are closely linked to gilt yields, so when gilt yields fall, so do annuity rates. Peter Magliocco, associate regional director of The Annuity Bureau, says the recent stampede has affected pension incomes: 'A man aged 65 with a wife aged 63 wanting to convert a £30,000 fund with a 50 per cent widows benefit, would get about £1,795 a year now, whereas in December it would have been £1,838 a year.' He does not advise annuity buyers to hold off in the hope of better times ahead: 'This is not sensible, as you'd have to get a significant increase in rates to make up for the income you'd be missing out on in the meantime.'

David Kauders, of gilt specialist Kauders Portfolio Management in Reading, Berkshire, predicts a stock market downturn before the end of the year or in 2007. 'People will need to save more in their pensions,' he says. 'Saving means less spending, which means sluggish economies and damage to equities, forcing interest rates down and therefore reinforcing the case for gilts.'

Mundy is not entirely opposed to gilts and believes there is a case for investors to look at the short-dated variety: 'The bull market has been very long and I am worried about a sudden correction. There is hardly an asset class that has not done well lately. There is an argument for looking at short-dated gilts or cash, which offers similar returns.'

Useful contacts:
www.gilt.co.uk
www.dmo.gov.uk