Sara Benwell explores what European Central Bank’s quantitative easing announcement means for pension schemes
Today’s quantitative easing (QE) announcement may have been the world’s worst kept secret, but ECB president Mario Draghi still managed to surprise some by unveiling a more open-ended and large scale programme that was bigger than expected.
In a bid to finally get deflation under control, the European Central Bank has committed to spending at least 1.1 trillion euros, in an expanded asset purchase program of 60 billion euros a month from March 2015.
The European Central Bank has committed to spending at least 1.1 trillion euros”
Furthermore, Draghi announced that this round of quantitative easing will be open-ended, “until we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term.”
Neil Williams, group chief economist at Hermes Investment Management thinks this is good news, as by “keeping the door open for more, the ECB will cement the impact of low borrowing costs, add liquidity, and, by trying to take the rug from under the euro, aim its first ‘bazooka shot’ at deflation.”
What does this mean for pension funds?
It’s important to remember that this is not the first stage of ECB QE.
Bill Street, head of investments for EMEA at State Street Global Advisors, argues “we must reflect on how much has been done already, as this is the third leg of a comprehensive purchase plan.”
The effects of QE in Europe have already been painfully felt by UK pension schemes”
In 2009 the ECB targeted covered bonds and in 2014 the asset backed securities purchase programme was established.
The pensions industry has already felt the effects of this, characterised by falling yields and, consequently, soaring deficits.
Matt Tickle, a partner at Barnett Waddingham agrees. “The effects of QE in Europe have already been painfully felt by UK pension schemes as the dramatic falls in long dated gilt yields in H2 2014 have led to a rapid increase in liability values, most often not matched by assets. “
David Stubbs, global market strategist at J.P. Morgan Asset Management, suggests that today’s announcement could push yields even lower.
He explains, “Today’s announcement from the ECB will encourage investors to get out of sovereign bonds, effectively pushing yields lower than they might have otherwise been.”
Today’s announcement could push yields even lower”
Not everyone is so pessimistic though. Tickle thinks we could actually see yields go up. “Immediate market reaction has been for a further fall in yields; however we think there’s a possibility that yields will rise from this level. The game of chicken with the ECB has been won by bond holders and if QE leads to real structural reform in Europe… then growth could surprise on the upside leading to an uptick in yields.”
Martin Harvey, fixed income portfolio manager at Threadneedle Investments backs up this view. “The experience of previous QE programmes suggests that the boost to growth and inflation expectations trumps the demand and supply dynamics if the policy is credible, and yields move higher. The ECB will have a tougher job convincing investors than the Fed or the Bank of England, but in general we see no reason why this would not be the case in Europe too. “
Looking for yield elsewhere
If Tickle is right, he believes this increase in yields “will follow through to gilts and start to unwind some of the pain for UK pension schemes”.
However, Danny Vassiliades, head of investment consulting at Punter Southall thinks that “by buying European sovereign debt, the ECB will increase demand for sovereign debt in the UK as investors look for alternative sources of yield.”
He continues: “This can only help to keep UK gilt yields lower for longer and may even reduce them further.”
Any lowering of gilt yields will increase the value placed on pension liabilities and may indeed increase deficits.
With UK gilts as low as they are, many pension funds may need to seek yield in more esoteric areas of fixed income, with higher risk and better reward profiles.
This can only help to keep UK gilt yields lower for longer and may even reduce them further”
For instance, Stubbs points out that “with the central banks buying sovereign bonds, that will help support issuance of corporate debt, as they are able to get good rates on both investment grade and high yield debt, so that is one place investors will be looking.”
An equity investment approach
We may even see pension funds turning to higher yielding assets such as equities. This is a trend that we’ve seen in the UK as trustees find they cannot fund their deficits through fixed income assets. In particular, Stubbs suggests “so-called bond proxies in the equities space such as REITs or utilities that have similar cash flow characteristics to fixed income may also benefit.”
This may force pension schemes to take a multi-asset approach to meet their income goals.
In fact, Stubbs argues that this is a multi-year trend. “Potentially over the next few decades we are in an environment characterised by a new style of income investing with less focus on core bonds and a desire to look across a more diversified set of asset classes. “