Written By: Matthew Craig
Matthew Craig looks at how an uncertain market is affecting decision-making at local authorities
Fixed income used to be a reliable, if not downright dull, element in a pension fund portfolio. While assets such as equities provided excitement, a healthy portion of government bonds, with a sprinkling of blue-chip corporate bonds, provided a solid base to a portfolio. Fixed income assets could be relied on to not fluctuate wildly in value and to pay out a steady income. But all this has changed; as a topical investment joke has it, fixed income has gone from a risk-free return to a return-free risk.
There are a number of reasons why fixed income is now a riskier asset than it used to be. We have seen a long decline in bond rates to extremely low levels over several decades, as central banks have conquered inflation and used low rates to boost economic growth. It is worth remembering that on “Black Wednesday” in 1992, when hedge funds bounced the UK out of the Exchange Rate Mechanism (ERM), a forerunner to the euro, the underlying interest rate in the UK was 10%. More recently, before the 2008 financial crisis, UK savers were earning around 5% on deposit accounts; now they will be lucky to get less than half that. As yields have fallen, bond prices have risen, to the point where they are widely regarded as being at a peak. Given the inverse relationship between bond prices and yields, if interest rates start to rise, many bond investors could see the value of their portfolios slump. In order to reduce the impact of a future interest rate rise, investors may hold more short duration bonds, or seek fixed income assets which maintain a spread over base rates.
Another factor preying on investor minds is the way that bond markets, particularly in Europe, have become distorted by recent central bank activity, namely very loose monetary policies. Due to fears of deflation and in attempts to boost growth, the recovery period since the global financial crisis has seen extraordinary measures, such as quantitative easing, which have kept interests rates at very low levels. Incredibly, there are now negative rates on an estimated 25-35% of the euro-area bond market, and the German yield curve is negative in bonds up to seven years in maturity. Why would investors accept negative rates, or a guaranteed loss? In some cases, regulations force investors to hold part of their portfolios in fixed income. Or investors may accept a limited loss as the price of downside protection if they are worried about the state of markets generally.
One result of the very low yields on government bonds in Europe is that investors have embarked on a hunt for yield. With interest rates not expected to rise in the UK or the Eurozone for some time, many investors, including local authority pension funds, have widened the scope of their fixed income allocations in recent years. Wiltshire Pension Fund, for example, recently awarded a £200 million mandate to Loomis Sayles, to be split equally between an absolute return fixed income element and a multi-asset credit part. In this way, investors aim to produce higher returns than those on offer from sovereign bonds and highly rated corporate debt.
One concern here is that with more investors giving their fixed income managers greater freedom over how to invest, assets are moving down the capital structure, accepting more risk and causing a crowding effect in the less liquid parts of the fixed income market. Nomura Asset Management head of global unconstrained fixed income, Richard Hodges, commented: “One of the big concerns from my perspective is a liquidity crunch.” He added that this meant taking steps to protect against volatility: “We can implement very efficient hedging strategies, which means we can capitalise on opportunities, but at the same time, we try to efficiently hedge fat tail risks, without reducing the income we can distribute.”
While investors are using absolute return, or unconstrained, approaches to fixed income, some local authority pension funds are becoming more focused on matching their liabilities with fixed income and other assets. For example, the LAPF Strategic Investment Forum, held in February 2015 in London, found that interest rate risk is seen as the biggest threat to funding levels by 32% of those present. This is ahead of longevity, 25%, equity markets, 21% and inflation, with 7%. Looking at these results, Hymans Robertson head of public sector consulting, John Wright, argued that because LGPS funds are still open, interest rate risk should not be a priority as it affects liabilities, rather than growth assets. He commented: “A minority of employers within the LGPS are more sensitive to balance sheet risks like interest rates, such as those required to fund on a Gilts basis as they approach cessation, in which case a lower risk approach to funding and investment may be appropriate.”
However, because liabilities have risen in value by more than assets in recent times, others believe that liability management is becoming more important. John Harrison, independent investment adviser to Surrey County Council Pension Fund, said: “The problem is that deficits are currently high and real yields are low. Any material shift within the sector towards liability-driven investing will probably need to be tied to improving funding levels.” AllenbridgeEpic senior adviser, Karen Shackleton, pointed out that interest rate risks are unrewarded risks for investors, so should be managed as effectively as possible. “LDI is one strategy that achieves that effectively and efficiently so I definitely think it will be on the agendas for discussion for the LGPS in the next 18 months or so.”
If LDI is on the agenda, then according to Aon Hewitt principal consultant, Calum Mackenzie, investors can take advantage of the fears over deflation to implement inflation hedging. Mackenzie said: “Since inflation started falling, we have advised an increasing number of schemes to separate their inflation risk from interest rate risk by increasing their inflation protection. LDI mandates enable schemes to use inflation swaps to pay a fixed rate of inflation, and receive whatever inflation turns out to be – at the moment this fixed rate looks attractive.”
If fixed income investing is about taking a view on where economic factors such as inflation and interest rates are going, then a major debate is whether interest rates will stay lower for longer, or start to rise in the next year or so. Fathom Consulting chief economist, Andrew Brigden, recently told the NAPF Investment Conference that forecasts that UK interest rates will start to climb in the near future are far too optimistic. In his view, rates will stay low for a long time, which means that pension liabilities will remain inflated by low interest rates raising the cost of pensions. As a result, he said DB pension funds are caught on the horns of a dilemma. “If the Office of Budget Responsibility (OBR) is correct and yields normalise, then DB funds will become better funded and there will be a huge demand for index-linked Gilts, with an excess demand of £500 billion.” But Brigden said he expected the OBR’s forecasts of yield normalising to keep being put back. Indeed, he warned that if UK sovereign debt yields remain low, eventually around 20% of UK private sector DB schemes will become insolvent. In this scenario, local authority funds would also find funding and generating an income a struggle, but inflation hedging would be a lesser concern.
What does this mean for pension funds’ fixed income allocations? Firstly, the search for yield will continue. As well as using high-yield assets, “credit substitution” is likely to be a trend, with investors using real estate, infrastructure and private debt as assets which can provide a reasonable income and diversification. At the same time, there will still be opportunities in sovereign bonds, but perhaps on a global, rather than domestic basis. Hermes Investment Management group chief economist, Neil Williams, commented: “The risk to financial markets later in 2015 may not be that the US Fed and the Bank of England are tightening, but they are falling ‘behind the curve’. And, while this may be conducive to equities and other growth assets, conventional bond yields, anchored by central bank support, look unlikely to sell off aggressively.”
In conclusion, fixed income will remain a core part of local authority pension fund portfolios. But funds will have to ask themselves what they want from their fixed income allocation and how they intend to get it. Policies such as QE, which have created negative yields in some countries, could have as yet unforeseen consequences. We still have to see if and how yields normalise in the UK, so fixed income investors should “proceed with caution” and ensure their risk management controls are in working order.