The period from the start of May to the end of August saw us 10-year bond yields rise by some 120 basis points – the sixth largest increase, in simple basis-points terms, of the last 25 years. Given the very low starting point of 1.63%, however, in percentage terms the rise is head and shoulders above anything that has happened in that period.
This is hugely significant for investors because, when it comes to valuation, pretty much all financial assets take their cue from secure government bond yields. Effectively they are seen as a proxy for what is known as the “risk-free rate of return”, onto which is added an appropriate premium for the extra level of risk an investor is taking with an asset – for example, the equity risk premium in the case of equities.
Since John Burr Williams wrote The Theory of Investment Value in 1938, it has been generally acknowledged the value of a company is the discounted value of its future cashflows and the rate at which those cashflows are discounted is driven by bond yields. This is one of the fundamental building blocks of investing and why – at least in theory – assets around the world are correlated with interest rates. The increase in bond yields in recent weeks – and thus in the cost of equity – has therefore put theoretical pressure on equity valuations.
However, while rising bond yields have negative implications for the intrinsic value of many global assets, there is one aspect of investment for which they are actually good news – pension fund deficits have an inverse correlation with rising bond yields because a fund’s liability is being discounted at a lower rate.
In articles such as Eye of the beholder, we have noted that there was once a time when final salary pension schemes were seen as ‘sexy’. as recently as 2007, large schemes were seen as so attractive entire companies – particularly those with projected deficits, such as technology services provider Telent – were bought just so an investment manager could run those pots of assets.
That option is not open to the value perspective but we are still keenly aware that rising bond yields are good news for companies with large workforces – the likes of BT and British airways and industrial giants such as BAE and GKN. These former ‘metal-bashers’ used to employ a lot of people to bash their metal but now the great majority of their workforces have retired.
Of particular interest to us are companies such as trinity mirror, where the assets of a large pension scheme are funded by equity rather than debt. However, any company with a pension fund deficit should have enjoyed seeing discount rates moving in their favour in recent months and, if these are maintained, should reduce pension fund deficits and cash injections as the next valuations are undertaken.