Pension problems are being highlighted in the UK but the issue could easily spread across the world. One main reason is because of the Pension managers have used bonds to fund the pensions. The So what is a bond?
Bond example
I lend the UK Government £1000 for 5years at 5% interest. At the end of the 5years I will get all of my money back plus the interest. I feel this is safe because I trust that the UK Government will pay me back. Now, in the jargon we have:
- Bond - a piece of paper issued by the Government which contains the details of this loan.
- Issue price - price at which the issuer originally sells the bond (£1000 in this example)
- Face value - amount the bond will be worth at maturity (£1000)
- Coupon - the interest that the issuer will pay on a particular date (in this case £50 a year for 5years total £250). The Coupon reflects the rate of interest at the time of issue in the Country it was issued. Coupon rate is fixed.
- Yield - the total return including coupon, and any tax or losses. yield is variable and changes according to market price.
- Maturity date - the date on which the issuer will pay the face value
Coupon relates to Official interest rates
If interest rates drop (as they have in recent years due to Covid) to say 2.5%, then, then newly issued bonds would get £2.50 per year ie only half. So the price of our example bond in the market place will rise from £1000 to £2000 (because the market has changed and you need twice as many new bonds to achieve the same interest income each year).
So this is an INVERSE relationship which means that as the rate of interest goes down, the price of bonds goes up because they have a fixed coupon attached to them.
If interest rates rise to say 10%, and £1000 bonds are now paying £100 interest per year, then my original bond which is only paying £50 per year would only be worth £500 in the market place (because I need twice as many of them to achieve the yearly income).
Although the following Youtube video has a title about Russia, it contains a good visual explanation about what's happening to pensions.