Written By: Matthew Craig
For all pension funds, bonds have moved from being a safe but dull investment asset to becoming an asset class of much greater potential interest.There are myriad reasons for this shift.
Firstly, recent macro-economic events, particularly the build-up of debt in certain Western economies, have raised doubts over sovereign debt – or gilts – that were a cornerstone in bond allocations. Few people could have expected a leading ratings agency to downgrade US debt as we saw happen this summer, and other G7 economies, such as France, have seen their triple-A rating under threat. The coalition government in the UK has pledged to maintain its AAA status, but low growth could yet thwart this aspiration. Another element for bond investors to consider is their exposure to areas such as financials and the Eurozone. Most investors have been shunning banks for some time now, given potential regulatory risks and the weakness of some financial institutions. And the ongoing Eurozone dramas mean that investors are now thinking twice about holding bonds of many of the European countries.
A second reason for the change in attitude towards the asset class is that corporate bonds are becoming a wider and more volatile asset class; pension funds saw valuations plunge in the credit crunch of 2008 and early 2009, only to see a strong recovery in 2009 and 2010. In addition, credit, which encompasses both investment grade and high yield corporate bonds, as well as assets such as leveraged loans and asset-backed securities, is now seen as a fertile hunting ground for absolute returns, which can benefit institutional investors. There has also been increasing interest in emerging market debt, which includes local currency and hard currency government debt, and emerging market corporate bonds.
Local authority pension funds are among those investors taking a much greater interest in corporate bonds and the other components of the credit asset class. Mercer principal and head of the local authority investment business, Joanne Holden, commented: “Quite a few of our clients are currently doing strategic reviews and we think there are better ways of accessing returns from bonds than just holding corporate bonds.
“High yield bonds are one subcategory being put forward by fund managers at the present time. For example, M&G Investments said that European high yield bonds now offer better value than investment grade bonds, and it has started to go back into high yield for the first time since 2009. However, it added that the high yield market still contained a sizeable amount of debt that institutional investors should avoid. Overall though, the case for high yield debt rests of a large spread over safer fixed income assets, giving investors a pickup in yield. According to M&G, bonds rated at BB or below can give an additional yield of 5.5% now, against a spread of 3.5% in May this year, which can produce better risk-adjusted returns for investors.
A crucial factor when assessing high yield bonds is the default rate. If this is lower than the market expects, high yield bonds should prove a useful way of increasing income without a disproportionate increase in risk. M&G All Stocks Fund manager, Jamie Hamilton, said: “For the first time since 2009 you’re getting well rewarded for taking on high yield risk. The market now looks more attractive than investment grade but forensic analysis is absolutely crucial – investors must find senior positions in bonds with the strongest covenants, issued by companies able to weather recession. Investors able to allocate to such bonds should see a significant improvement to risk adjusted returns.”
And Richard Ryan, manager of M&G Alpha Opportunities Fund, said: “Few market participants seem to have noticed the profound changes starting to take place in high yield. First you have panic selling by short term investors who bought in 2009 but are now spooked by the sovereign debt crisis – the irony is such investors typically ditch their most liquid, and often highest quality, bonds first.” Similarly, Baring high yield bond fund manager and head of credit, Ece Ugurtas, commented: “The European high yield bond market has been demonstrating vulnerability to recent events amidst the sovereign debt crisis, underperforming both the US and the UK high yield markets. As a result valuations have become more attractive across Europe.” Holden said that local authorities tended to have a range of views on high yield bonds as a potential investment, depending on their own particular circumstances, and factors such as the governance budget or the resources available to assess and monitor investment opportunities. “Some local authorities might see high yield as a growth asset, or even part of the alternative box, rather than part of the bond allocation. It depends on their objectives – we are seeing huge variations in how different local authorities are approaching this area.”
Traditionally, bonds are been seen as a low-risk asset, but their use for this purpose is undergoing a revaluation by many investors. Holden said that the average local authority allocation to bonds is around 17%. The volatility of the last few years has shown investors that this level of allocation to bonds will not protect pension funds if there is a significant allocation to equities. A much larger allocation of gilts and corporate bonds is necessary if the asset class is to act satisfactorily as a de-risking tool or liability matching part of a portfolio.
Another consideration for pension funds in the current climate is to make a bond portfolio work harder. “Investors don’t want to lose any capital value in their bond allocation, but high yield might play a part in expanding the opportunity set,” Holden said. One definite trend here is for bond managers to have more scope to invest on a wider geographical basis or to use absolute return-type mandates. “The target might be cash plus 2-3%. If bond yields are likely to rise in the future, it could be better to have an absolute return mandate than to just watch a gilt portfolio fall in value should yields go up, if investors can afford to do that,” she commented. Absolute return fixed incom mandates, which in theory should produce a steady return over cash, given the volatility of bond returns in the credit crunch and the period following it. This option looks particularly attractive to funds that saw bond returns drop sharply in 2008/2009, before making a recovery as investor confidence came back in 2009/2010.
Holden feels that many local authorities are now pondering their next moves with their bond allocation, having survived that rollercoaster ride with varying results. “Some pension funds will be thinking about using fixed income for liability hedging, while others will be looking to diversify their bond portfolios,” she said.
One way to diversify bond allocations is to give fixed income managers greater freedom over where they invest within the bond universe. Consultants stress that this should not be the freedom to chase high returns from the latest hot idea, but to produce steady returns by combining different sources of income. This means that investors should carry out sufficient due diligence to ensure that they understand where managers have the freedom to invest, what they can invest in and they should also make sure there are controls or rules to prevent a manager concentrating too much money in just a few areas of the bond universe. In this regard, the lessons of the credit crunch are very relevant; some investors got burnt by exposure to instruments such as CDOs within their portfolios, showing the dangers of investing without due care and attention.
Looking at the broader macroeconomic picture, one issue for investors to consider is that of inflation. Conventional thinking would suggest that loose monetary policy will lead to higher inflation levels, but Holden suggests that for most local authorities, inflation is not a major issue at present. “It seems counter-intuitive, because pension liabilities are linked to inflation. Inflation has been discussed at pension funds, but it is often seen as a short-term issue, and many expect it to fall back in the medium term.” She added that local authority funds have more pressing issues to contend with such as the Hutton Report and underfunding. In addition, indexlinked gilts, which are one way to hedge against inflation, are seen as very expensive and are limited in their supply.
For local authority pension funds, there is no doubt that corporate bonds – and indeed the full range of fixed income assets – have a role to play in reshaping investment portfolios to cope with a changed economic climate. Factors such as the Hutton Report, the changes to public sector pensions, the need to manage investment volatility and to maintain or improve funding levels will also influence bond investing. From being seen as a relatively safe and solid asset class, bonds look like being part of a more dynamic investment mix, as local authority funds seek to meet a number of different goals. This may well see bond holdings increase and bonds used in a range of ways in the future.