Finding the sweet spot for fixed income

Written By: Matthew Craig LAPF Investments

Matthew Craig discusses The changing attitude of LGPS investors towards bonds which now may play a role in multi-asset strategies or could be used tactically to balance income and growth

Fixed income has traditionally been an important part of a pension fund portfolio, but prolonged low interest rates are causing many investors to question the role of bonds. Members of the Local Government Pension Scheme (LGPS) are no exception to this. In the past, fixed income has been a counterweight to equities, providing diversification and stability to portfolios, but this is changing. Pension funds still want some of the key attributes associated with fixed income, such as a lack of correlation to equities, income and reduced volatility, but now they are looking at a wider range of assets for this.

Looking at the LGPS and their fixed income needs, we can see two important forces at work which share the same root cause. These two forces are firstly, the emergence of negative interest rates, which are part of the radical monetary policies introduced by central banks in a bid to stimulate economic growth following the global financial crisis of 2008-09. The second force is the programme of fiscal austerity pursued by the UK government, which is another result of the financial crisis. While quantitative easing and negative interest rates have made huge changes to the fixed income universe, the government’s austerity drive of recent years has altered the membership profile and cash flow requirements of LGPS members.

On the first issue, with ultra-low and negative interest rates on highly rated government and corporate bonds, pension funds either have to bite the bullet and accept that they may have to pay for the privilege of lending to certain borrowers, or find alternatives. Julian Pendock, chief investment officer at the London CIV, commented: “Investors are paying to borrow from the ECB, which is now buying corporate bonds; 11% of Eurozone corporate bonds have negative yields.” This has not happened overnight and many LGPS funds have altered their fixed income strategies to reflect the low yields on offer. For example, at the end of March 2016, Bedfordshire Pension Fund had a relatively low allocation of 3.56% to government index-linked Gilts with a higher allocation of 9.37% to absolute return fixed income. It should be noted that Bedfordshire has a 20% allocation to multi-asset strategies, which encompasses fixed income. Overall for the LGPS, at the end of March 2015, there was a 7.7% allocation to fixed income.

The fact that most investors now believe that the bond markets are in bubble territory, and that yields will eventually rise and values fall, is one reason why fixed income allocations have dipped in recent years. Quantitive easing has distorted asset prices in many asset classes. Pendock commented: “Many people believe that fixed income is now more interesting than equities in emerging markets. High yield and EM debt are areas where yields of 6-6.5% are possible, which is much harder in developed markets, where regulations on solvency and funding have created many forced buyers.”

As well as widening their fixed income allocations to include high yield and emerging market debt, LGPS funds are making more use of multi-asset strategies. Within the bond world, this can mean multi-asset credit funds, which can invest across the fixed income universe, from sovereign debt to more esoteric areas, such as mezzanine finance, distressed debt, direct loans or high yield debt. This approach is certainly one being considered by the London CIV, as Julian Pendock explained: “At present, boroughs have £4.1 billion in fixed income in a wide range of assets, with relatively little in common between them. One option would be a multi-asset credit approach, taking advantage of tactical opportunities in fixed income, without giving too much away to smooth the outcome.” And of course, while low yields on secure sovereign and corporate bonds are pushing investors into other areas of fixed income, low interest rates mean that pension fund liabilities are discounted at a very low rate, making them larger. Given that the LGPS funds are now carrying out a triennial valuation, this is significant. Any chances of rates rising in the UK in the near term have probably disappeared with the vote for Brexit in the recent EU referendum. Against this, Brexit could change the UK economy more dramatically than is expected. Independent macroeconomic research provider Fathom Consulting is concerned about the UK’s current account, which stood at around 7% of GDP at the end of the first quarter of 2016 – the second-largest deficit on record. It commented after the referendum: “In our view sterling has further to fall. It could fall 20% or more if markets decide that the current account ought to be brought rapidly back into balance.” If this happens, the Bank of England may have to raise interest rates, which would reduce pension fund liabilities, but it could damage other parts of the economy, such as the property market and consumer spending.

The other significant factor which is having an effect on LGPS thinking on fixed income is a shift from being cash flow positive to cash flow negative. With an ageing population, this shift happens slowly but it has been accelerated by the redundancies in the local government sector. UBS Asset Management strategist, multi-asset and solutions, Matt Bance, said: “Public sector schemes are remaining open to new contributions but austerity measures have led to significant cuts in the workforce. In the 2000s, it is estimated that 600,000 public sector jobs were added, but the OBR estimated that one million workers would drop out of the public sector workforce from 2010 to 2018. That is having a big impact on the contributions going into public sector pensions and they are having to confront this change head on.” Pendock commented: “LGPS members are now facing the same issues as pension funds around the world. Local government has not been ring-fenced from austerity measures and has lost a lot of active members. Discount rates have come in, increasing the liability side of the balance sheet and this all has a knock-on effect.”

In order to find the cash flows that they increasingly need to match pension payments for retired members, LGPS funds cannot rely on poor yields from investment-grade government or corporate bonds. Instead, as well as looking at multi-credit strategies, many pension fund investors are looking at other cash-generative assets, such as infrastructure, real assets and real estate. Even equities can be used as an income source, rather than for growth. Here, the move towards asset pooling could encourage LGPS funds to collaborate in order to invest in assets such as infrastructure. The government expects LGPS reform to boost infrastructure investing in the UK, and investors like the idea of getting a stable, inflation-linked return of around 4% from infrastructure. Like many other defined benefit funds, LGPS funds are likely to need income, while also closing a funding gap. In this position, UBS’s Bance said a multi-asset income portfolio could provide a 5% yield as well as growth. “With contributions no longer sufficient to meet outgoing payments, more funds are waking up to the need to be more cash-generative. In some cases, a multi-asset portfolio can help and we are seeing more interest in this type of approach from private and public sector funds, and also from investment consultants.” Bance added that while larger funds might have the skills in-house to create the right kind of portfolios to generate income and produce growth, smaller and medium-sized funds might use solutions provided by asset managers.

Looking at the LGPS structure as is stands, there is a lot going on which could affect how bonds are used. Asset pooling, the triennial valuation, the very low interest rate environment and now the UK’s apparent decision to leave the EU will all influence future investment decisions. Bonds are likely to be used in different ways than in the past, playing a role in multi-asset strategies, or being used to gain exposure to emerging markets or high yield and hence fast growth companies. Investors may also use bonds tactically, as they seek to balance income and growth in a fast-moving environment. Bonds will remain an important part of the investment toolkit for investors, but those investors need to become smarter and more flexible in how they use the tools they have to hand.