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Mike Keogh

The side effects of the remarkable demand for low yielding government bonds

Michael Keogh (Senior Investment & Economic Analyst) explains the some less than positive side-effects of low interest rates, as detailed in the latest Bank for International Settlements (BIS) report.

As uncertainty persists to the future form of the single currency, investors are paying a hefty price for liquidity. Core European bond yields are at record lows. Negative ten year government gilts are expected to linger given that they are below the explicit (or implicit) inflation targets of central banks. It appears for many it is the return of capital, and not the return on capital, that is of priority. With interest rates already near zero, low bond yields are a deliberate aim to stimulate growth by encouraging business borrowing and discouraging savings, leading to higher demand and employment.

There are, however, some less than positive side-effects of low interest rates, as detailed in the latest Bank for International Settlements (BIS) report. Firstly from a banking perspective, lower financing rates may tempt lenders and borrowers to delay re-pairing their balance sheet, or make in-sufficient provisions for impairments. This is arguably apparent within both the consumer and real estate sector, and may contribute to interest rates having to remain lower for longer than currently envisaged. There is the concern that ultra low rates in the developed world can have a negative impact on emerging (and growing) markets by pushing up exchange rates, causing inflationary and asset bubbles. Finally, as equity markets remain historically low and interest rates have fallen, pension deficits have soared. Pension liabilities are linked to bond yields. As yields fall, the present value of future liabilities rises. The Pension Protection Fund calculated that the aggregate funding position of corporate pension schemes in the UK has risen from a deficit of £-24.5bn in May 2011 to £-312bn one year on. This is unsustainable.

What does this mean for real estate?
The longer low interest rates persist, property should benefit from a rise in demand from pension schemes searching for income generation, as they seek a relatively stable, but probably lower return profile. In a low inflationary outlook, the real returns achievable through property are attractive. A diversification away from risk could provide a cushion to real estate valuations, given this years witnessed protracted broad re-pricing, but may also stimulate demand aside of the competitive prime and long lease segment of the market. With relatively high income and relatively low risk, we expect that until confidence returns to the financial markets, the global hunt for yield will push real estate holdings in a typical multi-asset portfolio higher. Initially this will favour the more mature, liquid property markets, but we may also witness an expansion into what have been typically more niche property sectors.