Bond bubble: How it hits pension savers
Should people paying into their employer's defined contribution (DC) pension scheme be concerned about the inflated value of government bonds?
About four million employees are members of such schemes, and 86% of them are paying their money into so-called "default" funds.
These tend to be partly invested in UK government bonds, in some cases heavily so if an individual is close to retirement.
These particular pension savers might not have noticed that the price of UK government bonds has had its very own bubble in the past couple of years.
"There has been a big inflation of government bond prices, which may not be over, and it may be some considerable time until they deflate, but at some point they will have to come back down to earth," says Laith Khalaf, pension investment manager at fund supermarket Hargreaves Lansdown.
"Gilts are seen as a very safe asset, but actually at their current prices there is a potential for capital losses."
Why have bonds risen?
There are three related reasons.
Both here and abroad, governments have cut interest rates to try to stave off recession.
This has had a knock-on effect on UK government bonds, known as gilts.
As the Bank of England base rate has fallen to 0.5%, the fixed rate of interest paid by the gilts has become correspondingly more valuable and their prices have risen.
Gilts have also been seen as a "safe haven" by foreign investors who have been buying them during the turmoil in the finances of the eurozone.
And the price of gilts has been further boosted by the Bank of England's policy of quantitative easing (QE).
Designed to drive down interest rates in the wholesale financial markets, and stimulate some economic growth, this extreme policy has seen the Bank buy up huge quantities of government bonds since March 2009.
It has spent £325bn on this project and, astonishingly, now owns about a third of all gilts in issue.
Spread your investments
The inevitable effect of this artificial demand has been to drive up the market price of these bonds.
For instance, according to the market data service Bloomberg, the value of the current 10-year benchmark UK gilt, redeemable in 2022, has gone up by 21% since it was first issued in February 2009.
What would happen if the Bank of England started selling its massive holding of gilts? Would the bond-bubble burst suddenly?
Superficially, the answer might be "yes".
But Moyeen Islam, a fixed-income strategist at Barclays, expects the Bank to manage the sales carefully, probably over several years, and to take care not to disrupt gilt prices too much in the process.
"I am certain they would not dump £325bn of gilts back on the market in one go; that would be madness, it will be a phased programme of sales, come the time," he says.
"The bank is very good at signalling to the market the timing of its operations [and] it is not clear that it would ever sell back the entire £325bn of gilts," he adds.
Such sales probably won't start to happen in the next year or so, either.
Speculation in the City is that the QE programme could in fact be expanded again soon, not shrunk.
Julian Webb, head of the DC savings business for Fidelity, one of the biggest managers of investments for DC pension funds in the UK, also cautions against any panic.
He says the vast majority of DC members are invested in balanced portfolios of shares, bonds and cash, and are not 100% invested in bonds.
"The key thing is to have a diverse portfolio, so if they were 100% invested in bonds they should be concerned they are relatively exposed to a single asset class," he says.
"If they are in a 'lifestyle' investment, that would direct them to bonds, so the key thing is to diversify within that, with a combination of UK gilts, overseas gilts, and corporate bonds."
The DC savers most likely to have a lot of their money invested for them in bonds are those closest to retirement, courtesy of the "lifestyling" process.
The general idea is that by gradually moving money into bonds as retirement approaches, these people will be protected against any sudden drop in value of their pension fund that might come from remaining largely invested in shares.
That proposition might be questionable if you think that gilt values could start falling some time in the next few years.
But Billy Burrows, annuity expert at the Better Retirement Group, points out that people within striking distance of retirement should not necessarily suffer.
"People typically buy an annuity - a pension for life - with their DC pension pots and that income is usually provided by an insurer who also invests their money in bonds."
"So in a swings-and-roundabout fashion, any fall in bond values prior to retirement would be offset by a rise in the income that the annuity would provide."
Action to take
The fact of the matter is the vast majority of DC pension savers take little or no active interest in what is being done with their money, once they have made the initial choice of fund.
If they want to check what is going on with their money, and track how much of their fund is in bonds, and indeed which sorts of bonds, what should they do?
Julian Webb at Fidelity has this advice: "They should not assume anything and they should certainly check".
"The easiest way is to phone their DC provider, or go on their website, and look at the fact sheet which gives a very detailed breakdown of where the fund is invested.
"Normally it shows a pie chart which shows where the money is allocated."
The Pension Regulator has been taking an increasingly close interest in the way that companies and trustees run DC pension schemes, to ensure members get a good deal.
"We would expect trustees to regularly review their strategy and have appropriate controls in place to alert them to potential risks, including market trends," said a spokesman.