Written By: Phil Redding
Return enhancing and liability matching (REaLM) assets tick many of the right boxes for schemes with long-term investment horizons, says Phil Redding of Aviva Investors
With bond yields remaining low, the challenge for schemes of meeting future liabilities is significant. Matching liabilities may be achievable, but the returns pension funds are receiving when buying good quality fixed coupon and index-linked UK government bonds are currently at historically low levels, making this difficult.
Low real interest rates mean schemes’ funding ratios are expanding, not reducing. This in turn places pressure on plan sponsors to increase their contributions, which they are reluctant to do in the current environment.
Will it get any better? We don’t expect it to in the short term. We anticipate investment returns to be lower and more volatile, and correlations between assets to be higher than those previously recorded. But there are some reasons for optimism. The evolution of fixed income markets and the increasing availability of inflationhedging income streams from other assets provide an enhanced range of options which, intelligently harnessed, could help your schemes’ funding position and improve long-term prospects.
Evolving fixed income markets
So what are these evolving opportunities? Emerging market debt issued in hard currencies, such as the US dollar, has been incorporated into fixed income diversification strategies for several years. But the growing sophistication of these countries’ domestic bond markets means many now have sufficient depth and liquidity to be potential investments in their own right. We believe the sovereign debt crisis has caused investors to reassess their attitude and exposure to domestic government debt. Many emerging markets are not burdened with large fiscal deficits, and may be offering higher returns for similar levels of risk to developed markets.
Issuance of inflation-linked securities is increasing with more governments now doing so, including some in emerging markets. This can provide protection from adverse moves in inflation and better enable a fund to meet its liabilities. Developments and opportunity are also presenting themselves in the high yield market. However, there are also opportunities for pension funds to invest into lowrisk and long-dated income streams provided by real assets such as social housing, ground rents and infrastructure. With bank funding restricted, the possibility for pension funds to invest into these areas is increasing. We expect such assets – collectively described as returns enhancing and liability matching (REaLM) assets – will play an increasingly prevalent role in pension fund solutions.
Secure and predictable income streams
We believe the defining feature of REaLM assets is that they can provide highly secure and predictable income streams over the long term. Relative to some other real assets, the capital growth potential of the asset plays a relatively minor role in determining its appeal. The secure, long-dated and inflation-linked income streams offered by REaLM assets have the potential to provide a good hedge against inflation and interest rate risks, and are expected to provide an enhanced return over index-linked Gilts. They can therefore help improve schemes’ funding ratios.
The long-dated nature of the income streams may offset the duration mismatch that normally exists when pension fund assets and liabilities respond with differing levels of sensitivity to changes in yields. Furthermore, the fact that leases are typically inflation-linked means they can act as an effective inflation hedge. In the remainder of this article we look at two REaLM assets in more detail – social housing and ground rents.
Social housing: a winning solution all round?
In our view, investment in UK social housing offers a win-win solution for pension schemes and social housing providers alike. For pension funds, real assets such as social housing, ground rents and infrastructure can offer longterm inflation-linked cash flows that can be used to match liabilities. For providers, pension funds are a welcome source of financing at a time when the government and banks are reducing their financial support for the sector.
The underlying dynamics of the social housing sector are compelling, with demand increasing and unsatisfied demand estimated at 2 million households. A large quantity of new social housing will need to be built over the next five years at a time when the sector’s primary sources of capital – government grant aid and bank lending – are being curtailed.
UK pension funds and annuity businesses are especially well placed to provide finance, and some asset managers acting for pension funds and insurers already have established track records in this field.
In our view, the social housing sector is among the most secure and conservative industries in the UK. It is highly regulated by the Homes Community Agency, and is also well suited to providing long-term cash flows from long-term leases and to providing indexation through the linkage of housing benefit and underlying rents to inflation (traditionally RPI, CPI from April 2011).
Under our approach to social housing, the freehold interests in good quality modern properties are purchased by a specialist social housing fund and leased to a registered provider or local authority for 40-50 years. Under the terms of the lease, the registered provider is responsible for letting the properties and for all ongoing repair, maintenance and void costs, and pays rent to the fund which is typically reviewed annually in line with the retail price index, with a 0% floor. At the end of the lease, ownership of the assets reverts to the registered provider, so there is full amortisation of the initial investment over the lease term.
We believe that this approach can offer advantages to all parties. The registered provider receives long-term finance that is consistent with its own cash flows. Meanwhile, the investor has access to what we consider to be a highly secure and stable investment that provides long-term inflationlinked cash flows, and could help to reduce any underfunding by providing a real return materially above indexlinked Gilts.
Ground rents – small but potent
Our ground rent strategy brings together large numbers of individual ground leases to create portfolios designed to provide specific risk/return and inflation-linking characteristics. Under a ground lease, the owner of a piece of land grants a lease for, say, 150 years. The lessee constructs a building on the land and pays the owner a ground rent, which is usually payable annually or semi-annually. All repairing and insuring obligations lie with the lessee.
The rent is typically subject to upward-only rent reviews on an inflation-linked or fixed-uplift basis. At the end of the lease the asset (land and building) reverts to the landowner, who can then grant a new ground lease.
As individual ground leases are often of relatively low value, especially in the residential sector, an institutional portfolio of ground rents requires a large number of holdings. However, given the extent of current opportunities to purchase residential and commercial ground rents, we do not expect any difficulties in ensuring diversity of ground-rent providers.
In the event of default, the owner of a ground rent ranks higher than any mortgagor, and is usually able to terminate the ground lease. The ground rent interest can then usually be sold to another party. Although rare, ground rent default can enable the owner of a ground rent to recover its capital, plus a substantial margin on top. This is because the market value of a ground rent is usually significantly smaller (typically less than 3%) of the capital value of the leasehold interests. i.e. the market value of the buildings on the land.
For this reason, ground rents usually have a very low level of default. Lessees naturally have strong incentives to avoid default and the amount charged for ground rent is usually relatively small.
Made for long-term investors
In our opinion, REaLM assets tick many of the boxes for pension schemes. This is not just because REaLM portfolios can provide unusually secure long-term, inflationlinked income streams. The potential for an enhanced return over indexlinked Gilts could also help improve scheme funding ratios. This excess return is primarily an illiquidity premium – it exists because REaLM assets are less liquid than index-linked Gilts. Fortunately, pension schemes are generally very long-term investors, and so are especially well positioned to exploit this opportunity.