Written By: Matthew Craig
Matthew Craig examines how attitudes towards fixed income seem to be changing and looks at why the LGPS seems likely in future to use an increasingly wide range of assets to deliver fixed income returns
Fixed income is an important asset class which has now become unappetising for the taste buds of most investors.
In dietary terms, fixed income assets have always been a healthy option, the green vegetables on the menu, rather than a juicy steak, or a rich dessert that diners really crave. Fixed income assets tended to provide security and stability, but steady, if unexciting returns. Or they did, until after the global financial crisis, when central banks on both sides of the Atlantic set about using quantitative easing and ultra-low interest rates to stabilise and support their economies. A side-effect of this is that the yield on highly-rated government bonds has dropped to the point where many long-term investors, such as Local Government Pension Scheme (LGPS) members see very little value in conventional fixed income.
As a result, fixed income allocations across the LGPS have been slowly dropping. The LGPS Scheme Advisory Board website shows that in 2013, the overall asset allocation to fixed income securities was 6.7% and to index-linked securities, it was 2.8%, but in 2016, these figures had dropped to 4.9% and 2.6% respectively. One reason for this is that fixed income is now less attractive than before, another is that LGPS funds, which have an 85% funding level in aggregate, need to generate returns in order to close their funding deficits. Thirdly, whereas insurance companies and corporate pension funds hold fixed income partly due to meet regulatory requirements, LGPS funds can and do hold more in assets such as equities, real estate or alternatives, for higher returns.
But LGPS investors are, no doubt, keeping an eye on fixed income developments. Not only have we seen the bizarre development of negative interest rates, where investors are, in effect, paying a government or institution for the privilege of lending it money, but some borrowers are now taking advantage of the demand for yield by issuing bonds with terms of up to 100 years. Mexico, Ireland and Belgium have all done this recently and now Argentina has joined them, with a 100-year bond, priced to give a yield just under 8%. Felipe Villarroel, portfolio manager at Twentyfour Asset Management, commented: “What this transaction tells us is that the current hunt for yield is as fierce as ever.” He added: “In our opinion it seems to be a very bullish trade and we see better value in other parts of fixed income markets.”
While a 100-year bond from Argentina is an extreme example, it nevertheless shows that finding value in fixed income is difficult in the current climate. This means investors need to be sure of their aims, when entering the asset class. John Jones, a senior adviser at Allenbridge Epic with extensive experience in local authority finance and pensions, said that investors need to decide why they are holding fixed income assets. “Why is it in your asset allocation? Is it to provide an income stream or as a liability-matching asset, or to provide diversification? If you are investing in it now, at this point in the cycle, there is very little return from core fixed income assets. It looks like rates are now edging up, with three votes for a rate rise at the last meeting of the Monetary Policy Committee (MPC) at the Bank of England. Rates in the US have picked up a little already.”
For many investors and those advising them, such as Jones, the most interesting dishes on the fixed income menu are away from government and investment-grade corporate debt, and further along the risk-return spectrum, or with strategies that used a mix of underlying assets, or more esoteric assets, to produce an income. Jones said: “If investors are looking for an income, then some are looking at multi-asset credit (MAC) products or even equities, as fixed income does not look like a good buy right now for generating income.”
Just as many investors now hold alternative assets to enjoy higher returns and more diversification than conventional bonds and equities provide, so within fixed income alternative fixed income has become a growing trend. It encompasses the likes of private debt and senior secured loans, mezzanine finance, asset-backed securities, structured credit, possibly emerging market and frontier market debt, and even niche areas such insurance-linked securities. By blending assets like this with more traditional fixed income assets, investors can obtain higher yields, although they have to take care not to take on too much risk in areas they might not know much about.
Whereas listed fixed income should have liquidity, private debt means tying up capital for three to five years. If there is an economic downturn in this time and the companies borrowing from a private debt fund suffer, then investors could lose out. This means private debt providers need to assess credit risks, ensure they are properly compensated and be able to hold the collateral or security for their loans. Some large corporate pension funds are developing their expertise in this area, as they step in to replace bank funding, but it seems local authority funds are more likely to develop their expertise, and use their firepower in areas such as infrastructure, or real estate, where they can obtain an income, with the prospect of rising capital values. Perhaps this reflects some of the differences between public and private sector institutions; whereas private sector entities are more familiar with financial engineering and assessing business risks, public sector institutions are, by nature and design, more inclined to build and manage tangible assets.
This trend is illustrated by the first investment steps taken by the new LGPS asset pools, which are prioritising areas such as equity investing, multi-asset funds, or real estate and infrastructure, ahead of fixed income. This makes sense, as the former assets offer more scope to achieve economies of scale, lower fees and better access to underlying assets for LGPS funds. As an example, the London CIV has launched eight funds, all equity-based, or seeking absolute or total returns. Peter Wallach, head of pension fund investment at the Merseyside Pension Fund, commented on the Northern Pool’s plans: “Combining our equity and fixed income assets is not an immediate focus for the three funds, not least because there is very little overlap between us in terms of mandates. Over time, no doubt, we will see mandates coalescing, but in the short term, we all have cost-effective arrangements in place.”
In the future, though, we can expect to see changes to fixed income investing at the LGPS pools. This will be due to both internal and external reasons. On the external side, the fixed income cycle would be reaching a turning point, with interest rates starting to move upwards. The Federal Reserve in the US has started to raise rates and move away from loose monetary policies. However, the uncertainties of Donald Trump’s regime and the fact a new Fed chair will start early in 2018 have slightly clouded the outlook. Nevertheless, US Treasuries are one of the ultimate hedging assets for investors. Amundi global head of research, Philippe Ithurbide, commented: “If risky assets plummet, US sovereign bonds will be a good macro-hedging instrument… unless inflation is down sharply and/or the Fed continues to raise interest rates.”
In contrast to the US, it seems that UK fixed income could become less appealing to investors, as a result of political upheaval and other factors. Mark Dowding, partner & co-head of investment grade debt at BlueBay Asset Management, recently said: “With 10-year Gilt yields below 1%, real yields are in deeply negative territory and look materially overpriced in our view. We favour bonds versus Gilts and more broadly see a bleak outlook for all UK assets looking forward with political upheaval likely to persist in the weeks and months to come.”
For mature pension funds with defined benefit (DB) liabilities, such as the LGPS, internal factors could also affect their attitude to fixed income. For instance, a growing number of UK DB schemes are now cashflow negative and this number will rise as existing members enter retirement. For some LGPS funds, the recent reforms brought this trend forward, as benefits for younger members have been restricted. At this point, many schemes have used core fixed income to meet their income requirements, but other assets such as property, infrastructure and private debt could be used for income in future. Fund managers Newton Investment Management and Capital Group recently joined forces to discuss with investors ways to produce an income, and they concluded that equities, multi-asset funds, as well as higher yielding fixed income securities can help generate growth as well as consistent flows of income.
So while traditional fixed income, such as government bonds, will play a role as an investment bedrock, it is likely that LGPS funds will utilise a wide range of assets, including alternative fixed income, in order to generate income, but also with some much-needed growth, in order to ensure that they can meet their liabilities as they fall due.