2016 has certainly been the year in which politics and economics have collided. The decision for the UK to leave the EU has bought attention to international trading agreements, which most of us had no previous knowledge or interest in.
We now await the arrival of a new president in the United States who won the election on the basis of making significant changes to US economic policy.
The world waits with more than a little apprehension with what a Trump presidency will deliver, but already there has been a market reaction, which, in the short term at least, has immediate financial implications for many of us.
The degree of interest we show in the value of our pension fund is likely to depend on our proximity to retirement. However, bad news might await anyone who compares the value of their fund before and after Mr Trump’s unexpected election victory – why so?
Pension funds invest in several asset types, but in most balanced portfolios important constituents are normally shares in companies (equity) and government bonds (gilts). The relative size of each asset type will depend on the age of the pension holder and their attitude to risk. In short, the more the potential gain with a particular investment, the greater the risk of loss. Company shares sit at the riskier end of the spectrum and gilts at the less risky.
It is the value of gilts that have declined sharply since the US election and for which I would offer an explanation.
What is a ‘gilt’?
A ‘gilt’ is a bond issued by a government and the term “gilt” or “gilt-edged security” is a reference to the primary characteristic of gilts as an investment: their security. This is a reflection of the fact that the British government for example has never failed to make interest or principal payments on gilts as they fall due. It is for this reason that pension funds regard gilts as an important asset in any balanced portfolio.
The key terms involved with bonds are:
- The issuer of the bond receives cash from the purchaser
- A promise by the bond issuer to re-pay the bond holder in full after an agreed period (typically 10 years) and in the meantime, to make a fixed interest payment (yield) every year until the bond matures.
What can cause gilts to lose value?
At the outset it is important to note the relationship between bond yield and bond price. When a bond is issued, the yield applying for the term will be fixed as a percentage of the price at which the bond was issued. By way of example, a bond with a price of £1,000 paying a yield of 1.5% will pay the bond holder £15.00 per annum in interest.
The bond however can be re-sold by the bond holder at any time during its term, the importance of which is that the bond price at point of re-sell will depend on the attraction of the yield being paid. In our current low interest rate environment, yields set for gilts have been considered reasonable value and as such, bond prices have maintained or increased their value over recent years. If, however, there becomes a prospect of interest rates increasing, the yields payable on gilts can look less attractive.
Returning to the example above, a bond holder selling a bond with a nominal value of £1,000 in an environment where the general level of interest rates are higher than today, might need to offer a yield of 2% rather than the 1.5% applied at the time the bond was issued, to achieve a 2% yield. Furthermore, the bond price would need to be reduced by 25%. In other words to make the £15.00 payable equate to a 2% yield, the bond price would need to be £750. This, very simply, is how the value of bonds can reduce or increase, and provides the basis on which pension funds continually value their (our) portfolios.
So what has all this got to do with Mr Trump?
A key campaign commitment given by the President Elect was for the US Government to borrow significant sums of money to finance a huge growth in capital expenditure. Such a large increase in borrowing is widely expected to lead to an increase in interest rates, and the size and importance of the US economy means that interest rates all over the world are also likely to rise, bringing to an end the long era of ultra-low interest rates. As outlined above, higher interest rates will have a negative impact on the price of government bonds and be reflected, at least in part, in the value of our pensions.
Andy is an experienced sales and finance professional with over 25 years’ experience in sales aid leasing. Andy is widely recognised as an expert in business finance and has in recent years focused his attention on developing partner sales teams develop an understanding of how businesses secure project financing. His training programme – Finance Unlocked – is a highly rated customisable course and is offered at no cost to partners.
If you’re interested in helping your sales team overcome finance-related hurdles during the selling cycle, please get in touch with Andy on 07966 114 243 or email here.