Bonds, the largest Asset class in the world, is often overlooked outside of individual’s pension and investment portfolios. This blog will focus on Sovereign Bonds and how they relate to other financial assets. The European sovereign bond market is being used by the ECB in an attempt to increase inflation of which the goal is 2% growth per year. The mechanics and macro-economic reasoning behind the Quantitative Easing (QE) program are often written about, this blog will look at some of the effects it has on individuals finances.
There has been increased volatility in the yields of Sovereign Bonds over the last number of weeks around the possible end to QE in March 2017 and the fashion which Britain will exit the European Union. Analysts use Bond yield curves to interpret changes in global markets. The Supply and Demand of long term Bonds influences the shape of the yield curve. Click here to view the movements in the ten year German Bond yield to the uncertainty in the market.
On Thursday 20 October the European Central Bank President Mario Draghi stated “It’s quite clear that our decisions in December will tell what we do in the coming months,” he also went on to say “My perception is that a sudden stop is not in anybody’s mind”. If QE continues, as many analysts believe it will be for a further six months up to September 2017, what will that mean for individuals on the run up to retirement and for those repaying loans? The following trends should continue if Bond yields remain low and Interest Rates constant or reduced further (all other things being equal):
- Poor value Open Market Annuity Rates. Annuity contracts are Pensions for life that secure the Annuity rate at the date the contract is purchased. This rate is locked in and will not be changed in the future regardless of market conditions. Open Market Annuity rates are linked to the ten year German Sovereign Bond yield. The German Sovereign “Risk Free” rate of return is currently 170 (close of business 27 October 2016). At retirement under a Defined Contribution pension scheme, AVC, Personal Pension or PRSA arrangement an individual will be presented with two post retirement vehicles of which one must be selected. Option 1) An Annuity Contract and Option 2) Approved (Minimum) Retirement Fund . Due to the historically low German Bond yields, Annuity Rates today vary slightly depending on the terms of the contract, let’s assume a rate of 3% is secured, the individual is betting that they will live for another 33 years just to get a return of the initial purchase price.
If QE is extended and Interest Rates remain unchanged or negative the Open Market Annuity Rates should continue to remain low and an unattractive option for individuals at retirement. Some individuals prefer to secure a set pension at retirement and not need to monitor and review an A(M)RF policy in the aim to achieve investment return. Now the Annuity option is seen as the more risky option as the likelihood of the individual dying before they receive their initial amount invested has increased as a result of the reduction in German Bond yields.
- The Cost of Credit should remain low; this is beneficial for borrowers as they pay less interest on variable rates loans. Low Interest Rates are an attempt by the ECB to increase the flow of currency in an economy, to increase inflation. Inflation is achieved by increasing capital investment and consumption and a reduction in savings. The Central Bank of Ireland released interesting data in September detailing Variable Mortgage Interest rates on new lending up to the end of Q2 2016, the data is available to download by clicking here. The first graph on page 1 illustrates the change Variable Interest rates charged, from between 5% and 6% in 2008 when inflation and interest rates were high. Since 2011 the Mortgage Interest Variable Rate for new lending has stayed between 3% and 3.5% since 2011.
This is an excellent time to be a borrower; however it is worth remembering that the low interest rate strategy being used is an attempt to increase inflation. When inflation increases prices rise and so too will the interest rates charged for the provision of credit. It would be prudent to implement a buffer when agreeing your repayment levels on new debt, to take into account interest rate changes particularly on long term debt. When bond yields rise this will push up medium and long-term Eurozone interest rates and in turn the cost of credit.
As we can see from the above examples low Bond yields have benefited borrowers. Individuals who traditionally would not have taken part in the markets after retirement are now investing in A(M)RFs as they are perceived to be a the less risky investment option at retirement, this is a negative effect of low bond yields. The examples above will have the opposite effect should Bond Yields increase. The market will have to wait for the ECB’s December announcement for clarity going in to 2017.
Should you have any queries in relation to the above or wish to discuss your retirement options, please do not hesitate to contact us on 061 518365.