Pension funds in the strongest financial position for 2 1/2 years are helping U.K. government bonds reverse the deepest losses since 1994.

Bolstered by the best stock performance in four years and a surge in bond yields, pension funds have enough assets to cover 98 percent of their future commitments, the highest level since June 2011, according to the Pension Protection Fund. It means retirement plans can add to bond holdings as they seek predictable revenue and reduced vulnerability to price swings and inflation.

A sale last week of long-dated U.K. inflation-linked bonds, typically owned by pension funds, drew record demand and gilts are outperforming Treasuries and Japanese government debt this year. While analysts and investors predict rates on developed-market bonds will rise as the Federal Reserve pares asset purchases, some say demand from pension funds will limit the increase.

“Any increase in yields will attract demand in inflation-linked instruments from pension funds looking to match liabilities, particularly in the U.K.,” said Saker Nusseibeh, chief executive officer at Hermes Investment Managers, which oversees 26.1 billion pounds ($43 billion) of assets.

Gilt Returns

Gilts returned 2.1 percent in January after falling 4.25 percent in 2013, Bank of America Merrill Lynch indexes show. German bunds gained 2.2 percent, while U.S. Treasuries added 1.6 percent and Japanese bonds climbed 0.8 percent.

U.K. bond yields rose to 2.40 percent on an aggregate basis this week from a record low of 1.52 percent in August 2012, the indexes show. The yield reached 2.61 percent in December, the highest in 28 months, as the Fed announced plans to start reducing the amount of bonds it buys and accelerating growth in the U.K. prompted investors to bet the Bank of England could start raising interest rates as soon as this year.

The rate on 10-year U.K. government bonds will rise to 3.40 percent in the fourth quarter from 2.71 percent at 9:38 a.m. London time today, according to the median forecast of 24 analysts in a Bloomberg survey.

Liability Matching

“We do expect bond yields in the European market to rise because of the Fed policy and because of the growth outlook,” said Lukas Daalder, a money manager at Rotterdam-based Robeco Groep NV, which has $260 billion in assets. “But we can’t envisage yields rising substantially because the recovery remains weak. And there is always demand for bonds from those seeking to match liabilities. As a general rule, they are unlikely to underweight government bonds.”

Pension funds use government yields as a discount rate to measure future obligations, meaning the surge last year helped them to reduce their liabilities. Stock gains also improved their funding levels, allowing them to buy bonds to meet their long-term liabilities. The FTSE 100 Index (UKX), which jumped 14 percent in 2013, is 4.4 percent lower this year.

Defined-benefit pension plans were 97.6 percent funded in December, according to the latest data published last month by the Pension Protection Fund. PPF monitored risks faced by 6,150 defined-benefit pension plans worth 1.13 trillion pounds.

According to JP Morgan Chase and Co., pension-fund demand will cap gilt yields as Fed tapering damps the appetite for fixed-income assets. The bank estimates that global bond supply will outstrip demand by $200 billion this year, compared with $140 billion in 2013.

“As the gap between liability and assets narrows, pension funds have a strong incentive to lock in the improvement in the funding gap,” said Nikolaos Panigirtzoglou, global market strategist at JPMorgan in London. “Bond demand from pension funds and insurance companies should increase as bond yields rise. This will help to provide a cushion from the impact of the Fed’s tapering.”

Source: Bloomberg Businessweek