Low rates mean long-term liabilities

Over the past decade we have become used to interest rates and inflation being very low. Rates seen at the time of Black Wednesday in 1992 of 12%-15% seem unreal compared with today's 4.75%.

It is not only today's cost of borrowing that is low. New research shows that long-term interest rates, adjusted for inflation, could be at their lowest for the past 300 years.

Long-term interest rates correspond to the yield on government bonds with maturities of up to 30 years. Since the coupon remains fixed, as prices increase yields decrease and vice versa. As government bonds have been traded for more than 300 years, analysis can show where we are today in comparison with the past.

Research by Professor David Miles, an economist at Morgan Stanley, shows today's interest rates are virtually the lowest since the 18th century. Such low long-term rates would be explicable if the outlook for economic growth were low, or risk aversion among investors was particularly high. But nei ther is the case. Nor can it be shown that savings rates have risen sufficiently across the globe to drive up asset prices.

Prof Miles concludes that these low interest rates are therefore unsustainable and likely to be corrected. If he is right, and long-term interest rates were to rise, this would be a boon for companies facing a pensions deficit.

Since companies have to value their future pension liabilities using expected future returns, low long-term rates have caused problems for companies in meeting their pension liabilities.

There are signs that Prof Miles may be right. Things are beginning to change in the United States. Last month Federal Reserve chairman Alan Greenspan said the low, long-term interest rates were a "conundrum". US 10-year treasury yields have since reached 4.55% from a low of 3.97%. But this represents the movement in nominal interest rates. Once inflation expectations are taken into the account, the real yield has remained unchanged.