The dangers of low interest rates
THE Bank of England Monetary Policy Committee has announced a cut in interest rates of 0.25 per cent, together with £60 billion (S$104 billion) of gilt purchases and additional purchases of up to £10 billion of UK corporate bonds. The bank has cited the potential to do more of the same. Since it seems very unlikely that lower borrowing costs from current extreme levels will have any meaningful direct impact on consumer or corporate actions, the aim must be largely to boost confidence.
This further loosening in monetary policy will accentuate the already dire state of (defined benefit) UK pension funds as it will help to sustain gilt yields at extreme artificially low levels. For a typical pension fund, a fall in gilt yields of 0.5 per cent increases the value of the liabilities by 7 per cent to 8 per cent. Depending on the amount of bonds held in the fund and the level of funding, this could increase the pension fund deficit by about 5 per cent of the value of the liabilities. The Pension Protection Fund has reported that UK pension fund deficits increased by £89 billion during June 2016.
As the latest infusion of monetary stimulus contains a corporate bond component, corporate bond spreads over gilt yields are liable to reduce, exacerbating the situation as pension fund liabilities are often valued using corporate bond yields.
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