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Bank of England rate hits nine-year high!

The Bank of England has just raised its base interest rate to 0.75%. So what happened the last time rates were at this level, and what did this mean for LDI investors? We take a trip down monetary memory lane to find out.

So the Bank of England has raised rates to the dizzying heights of 0.75%. While the effect of this is broadly negligible for LDI investors with pension liabilities stretching out over the next 50 years, it did get us thinking back to when rates were first cut to 0.5%. On 9 March 2009, at the peak of the credit crisis, the government bond yield curve was as shown in the chart below. The thing that jumps out most is the steepness of the curve. It implied significant rate hikes in the future, with the base rate reaching around 5% by 2018! 

At the peak of the credit crisis, the government bond yield curve implied that base rates would reach around 5% by 2018!

Obviously the benefit of hindsight is a wonderful thing, but it does highlight the cost of inaction. Pension schemes may have baulked at buying government bonds whose yield had fallen around 1% over the past year, with the expectation that rates were only likely to go one way from such low levels. In retrospect, when looking at the future level of rates implied by government bond prices at that time, it was a very attractive time to hedge.

Fast forward to today and the yield curve is nowhere near as steep, but does imply a modest pace of interest rate increases. While this is in line with our central view, there are numerous risks such as the Brexit outcome, the ending of this economic cycle and a potential Chinese 'hard landing'. The deterioration in the outlook for the economy from any of these risks could cause the BoE to reverse course and bond yields to fall.

Fast forward to today and the yield curve is nowhere near as steep, but does imply a modest pace of interest rate increases

We believe that when setting their liability hedge ratios, pension schemes should be comfortable that the level of risk they run is in line with the strength of their interest rate view. For example, if 50% of a scheme’s liabilities are unhedged, this provides the same level of standalone volatility to that scheme’s funding level as a 25% allocation to equity (based on a standard scheme liability profile).

Pension schemes with unhedged liability risk need to be sure that the level of that under hedge is in line with their conviction that in nine years' time we will not again be looking back in surprise that interest rates have not moved as currently priced!

 

 

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