UK election could trigger rating downgrade

UK pension funds should brace themselves for bad news after today’s election – no matter what the result – if the country’s credit rating is downgraded.

According to Margaret Frost, London-based head of worldwide fixed interest research for Towers Watson, while the core of any pension fund’s fixed interest exposure has traditionally been sovereign bonds, this might not be the case in the future.

She said in an interview this week, before the UK election, that it would not be a big surprise if the country was downgraded to AA rating for its sovereign bonds (gilts) after the final result is known.

“This has been a most disingenuous election campaign from all parties,” she said. “None has been prepared to say exactly what will be required to restore financial health after the election. If the UK goes to AA it probably won’t surprise the market that much. The real milestone would be if the US were to lose its AAA rating. That would have a big ramification around the world. That’s not our central scenario (at Towers Watson) but it is a risk.”

Frost, a former bond manager at the Kuwait Investment Office, which is the internal manager for the Kuwait Investment Authority sovereign fund, says that the fault lines in the market are in sovereign debt rather than corporate – not the least being in the Eurozone but also the UK.

She says the damage to investors tend to be done following downgrades, given that defaults are very rare.

She says her personal opinion is the world is years away from the US dollar not being the world’s default currency, although monetary policy was currently at a crossroads.

“It’s obvious now that the short end of the bond market is anchored at or around zero in most countries, except Australia and Canada and some resource-rich nations. At some point, interest rates will have to go up, but when? As an interest rate investor it’s a conundrum. When does the Fed (US Federal Reserve) start tightening? There are a lot of themes which bond managers are grappling with.”

For UK pension funds, a downgrade of the country’s rating would hurt average valuations.

According to Towers Watson’s annual global asset allocation survey, for periods ending last December, about 31 per cent of the UK’s US$1.79 trillion in pension funds assets was invested in fixed interest. Worst affected will be the 61 per cent of the total relating to defined benefits funds. Of all UK funds, about 80 per cent of assets are invested domestically.