Mean reversion a ‘dead cert’?

Albert Kuller examines past and present gilt yield trends and what this means for mean reversion assumptions

The concept of ‘mean reversion’ has been widely debated in the pensions industry in the past 12-18 months.

Some believe that the current yields available on gilts are so low that yields will certainly revert to a longer-term average (also known as an arithmetic mean) and that this assumption should dictate a more ‘appropriate’ measure of a long-running average yield.

So what constitutes the longer term? At one end of the scale we could use the average yield since the inception of the series - which was 1703 for 10-year gilts! Alternatively there are the high interest rates experienced in the 1980s or the yields experienced in the boom years leading up to the financial crisis.

On 25 June 2012, the 10-year zero coupon gilt rate, as calculated by the Bank of England, closed at 1.80 per cent. The data series, provided by the BoE, dates back to 1982 and in contrast to the low yields highlighted earlier, the highest yield recorded to date was 15.15 per cent on 18 January 1982.

So, how likely is it that the current situation will persist?

We calculated the average yield for the 10-year zero coupon gilt over the last 10 years as 4.19 per cent. The corresponding standard deviation, a measure of how volatile the asset price is over each trading day, was calculated to be around 0.75 per cent over the same period.

Using this information we can observe that the 10-year zero coupon gilt yield in June was around 3.2 standard deviations away from the 10-year average. If we assume that investment returns are normally distributed, statistically speaking, the probability of a yield this low or lower being observed is 0.069 per cent.

In other words, it is an event expected to occur once in every 1,455 days (four years).

Using a 20-year average of the 10-year gilt yield you arrive at an average yield over the period of 5.4 per cent, and the 1.8 per cent yield or lower should only occur in 1.7 per cent of observations.

The 30-year average led to a probability of observing a 10-year gilt yield of 1.8 per cent or lower about once in every 31 outcomes, i.e. a probability of 3.2 per cent.

This may seem startling. How can it be that the likelihood of observing a gilt yield lower than the current level is less likely using data based on the last 10 years’ data (when gilts yields have been lower in relative terms when compared against previous periods) than over the last 20 or 30 years when rates have historically been higher?

The answer lies in volatility. By only looking at data over the past 10 years, it appears that the current 10-year gilt yield is a less frequent occurrence in comparison to when we include the more volatile returns experienced during the 1980s and 1990s.

Having said this, no matter which period we examine, it appears that gilts returning yields of around 1.8 per cent is a very rare occurrence. Therefore, no-one would deny that the current low yields available on UK gilts are out of the ordinary.

Having said that, we would advise restraint before investors assume that mean reversion is a ‘dead cert’.

Twenty-five years ago few people would have believed that an economic powerhouse could transform into the poster boy for negative returns on risky assets with record levels for debt to GDP ratios. What started out as a statistical anomaly in Japan turned out to be an economic reality; this transition appears to have now firmly asserted itself as the modern day norm.

The UK has already experienced something resembling half a decade of lost growth. One of only two G20 countries to have entered into a double-dip recession, the domestic economy is suffering from uncomfortably high national debt levels and has little space for fiscal policy changes.

While we wouldn’t necessarily suggest that the UK is heading down the same path as Japan, we do believe that there is a lesson to be learnt: making assumptions with regards to the direction of future gilt yield movements – based on statistics, long-running historic averages or similar quantitative approaches - provides an incomplete picture of economic reality and can serve only to distort the investing mind set.

Written by Albert Kuller, investment consultant at Capita

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