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Blow for annuity holders as gilt yields hit record low

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Written by: Adam Lewis
09/06/2016
The yield on 10-year UK government bonds today dropped below 1.25% for the first time ever, which while good news for bond fund investors, is bad news for anyone holding an annuity.

Having stood at over 2% this time last year, the yield on 10-year gilts today bottomed at 1.22% (so far), which is the lowest figure since data was stated to be collected in 1989.

With bond prices typically rising when yields fall, this could prove a boon to those holding bond funds, but Hargreaves Lansdown’s senior analyst Leith Khalaf says it will be a blow for people buying annuities.

“Annuity rates tend to fall after falls in gilt yields, meaning less income for pensioners buying an annuity,” he says. At the same time he says pension liabilities increase and deficits tend to widen.

By comparison, he says equities start to look more attractive in this environment. “Getting a 3.5% to 4% dividend yield looks increasingly appealing as gilt yields fall,” he says.

Explaining the boast to bond funds, he says: “A bond with a price of £1 paying an income of 5p a year has a yield of 5%. If the price of that bond rises to £1.10, the 5p income remains the same, so the yield falls to 4.55%.”

While all eyes have been on the EU referendum campaign gilt yields have been slipping fast, so what happened?

Khalaf says: “The US Federal Reserve is backing away from interest rate rises following wavering employment data, and in Europe the central bank is pumping billions of euros into the bond market every month in the form of QE, both of which have served to drive yields down.

“The low yield on government bonds paints a pretty pessimistic picture of the global economy, and suggests we are set for an extended period of low or negative inflation, and weak economic performance. The question though is whether one can really trust an indicator which has been so heavily distorted by central bank stimulus measures.”

As an investment in themselves, Khalaf warns that gilts still look like a dicey proposition, offering little in the way of return for taking on a “bucket-load of capital risk”, if sold before maturity.

“However the strength of the bond market has consistently confounded professional investors, dating back to the beginning of 2010 when bond guru Bill Gross told us the UK government bond market was sitting on a bed of nitroglycerine; yields at the time stood at 4%,” he adds.

“In the US there is an old saying that you shouldn’t fight the Fed, and over here you probably shouldn’t fight the Old Lady of Threadneedle Street either. Central banks have been successful in driving yields down, to the consternation of the myriad of respected investment managers who have baulked at investing money at such paultry rates of return. It goes to show sometimes even the best, most rational investors get things wrong.”

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