Written By: Matthew Craig
Fixed income is a highly important and challenging asset class for pension funds. It is the ballast for many funds, as they mature and need to ensure their assets move in sync with their liabilities. But from being a rock-solid asset, fixed income is now arguably more unstable than ever, given the huge liquidity pumped into the world’s financial system since 2009.
The reaction of central banks to the 2008-09 global financial crisis has severely reduced the income from government bonds in countries such as the UK. Now, some developed economies, such as the USA and the UK are looking to start raising interest rates, while Europe still battles low growth and deflationary pressures. Morgan Stanley Investment Management (MSIM) head of European fixed income, Richard Ford, commented: “Local authority funds are concerned about the impact a rising interest rate environment will have on fixed income investing. Firstly, there is concern over capital preservation in a rising rate environment. Secondly, there is a concern over credit valuations, as there is clearly a hunt for yield and we are seeing a strong demand for the illiquidity risk premium.” Pictet Asset Management chief strategist, Luca Paolini, said: “2013 should mark the end of the most vigorous phase of the bull market in developed market equity and bonds. Not only will monetary stimulus deliver diminishing returns in the years ahead, but investors must also face up to the fact that cheap assets are in very short supply.”
Dorset County Pension Fund head of treasury and pensions, Nick Buckland, said his fund has altered its approach to fixed income in the light of changing conditions. “Two to three years ago we decided to allocate half of our fixed income portfolio to an inflation hedging mandate. The remainder is invested in corporate bonds. The split is around 50/50, and we think that it gives us a good balance of liability matching and some growth.” In numbers, Buckland said that the recently revised strategy has 22% in fixed income, with 12% in an inflation hedging mandate and 10% in corporate bonds. The desire to hedge against inflation indicates the exposure many funds feel to this risk, given its potential impact on pension payments and the possibility of rising inflation as the Bank of England’s unprecedented programme of quantitative easing is unwound in the future.
The London Borough of Lambeth Pension Fund is another fund with inflation concerns. Its pension fund manager, Andrien Meyers, explained that in 2010 it had a 30% corporate bond allocation as part of its asset allocation. Following a major overhaul of the fund’s investments, it has moved a third of its corporate bonds, around 10% of overall assets, into a liability-driven investing (LDI) approach. “We wanted to get more inflation and interest rate risk coverage. We did an in-house exercise that showed that our interest rate risk coverage was 7% and inflation coverage was nil. We were not an outlier among local government pension funds [with those coverage levels] and we are now looking to target 25% coverage for interest rate risk and 20% for inflation with the change to the fixed income allocation.”
At the West Midlands Pension Fund, nearly 20% of the fund is allocated to fixed interest with half in Gilts. Geik Drever, director of pensions at West Midlands, commented: “The balance is a range of other areas designed to deliver higher returns than those available from developed market government bonds, and includes corporate bonds, EMD, convertibles, mezzanine and other niche areas.”
While it is undoubtedly prudent for funds to guard against interest rate and inflation risks, which have little upside for funds, views among economists vary on where the global economy is heading. Hermes Fund Managers group chief economist, Neil Williams, said: “With the US and UK now growing at potential, inflation probably troughing, and policy makers mindful of bubbling asset (especially, house) prices, even we believe rate rises are coming. This suggests at some stage a re-rating by financial markets needing to gauge how severe the interest rate ‘normalisation’ will be.” Williams added that he expects to see gradual and limited rate rises, with a possible rise in the UK this November, but with only small steps taken. He attributed this to a two-speed recovery with weakness in the Eurozone, a slowdown in China and Japan and UK barely back to “square one” in terms of reclaiming lost output since the crisis. He added that central banks have a critical role to play in ensuring a smooth transition to higher interest rates: “With the Fed holding 25% of US Treasuries, the Bank of England one third of Gilts and the Bank of Japan heading for a third of JGBs, they have too much ‘skin in the game’ to want to catch us off guard.” MSIM’s Ford said that the path and the pace of interest rates are important considerations for fixed income investors. “The path is relatively clear, but the pace is a key question, because of the relatively steep yield curve. The market is pricing in higher yields, however the timing is uncertain. My view is it will likely be 2015, not 2014.” Ford added that another factor to consider is the use of macro-prudential policy as a substitute for higher rates in the short term. “There is no clear playbook on how macro-prudential policy will link to monetary policy”, he commented.
With government bond rates at record lows, yields on fixed income in general have been under pressure. At the West Midlands fund, Drever said: “Many areas of the fixed interest market trade on very low yields and offer low prospective returns. This environment does not make it easier to price risk, either.” This environment has led to some pension funds taking an unconstrained approach to fixed income, with more use of high yield, emerging market debt and secured loans, in addition to corporate bonds, to generate a higher income. Of concern is that this is now a crowded trade for investors, or that investors are being pushed further out on the risk spectrum in return for higher returns. MSIM’s Ford commented: “People are asking if there is still value there? This has led to an increase in the demand for an illiquidity premium. There is an acceptance that you are paid for default risk, price volatility and illiquidity risk, so to increase the payout, you may have to take on more illiquidity.”
At the same time, taking an unconstrained approach to fixed income, with an absolute return focus, could help protect investors if interest rates rise and push up yields. An interesting point here is that absolute return fixed income investing is, arguably, an active investing approach. This flies in the face of the recent proposal from the Department for Communities and Local Government for more passive investing by the LGPS; it may be hard to beat the market in efficient equity markets, but in fixed income markets distorted by recent central bank policy, active investing is arguably a sensible approach.
On the question of benchmarking fixed income, absolute return approaches are more likely to use a cash plus benchmark, of cash plus 4-10% depending on how much risk an investor is willing to accept. Dorset’s Buckland commented: “We now use the fund’s liabilities as the benchmark for the inflation hedging part of the portfolio, and an iBoxx index for the corporate bond element. I think there is something to be said for cash plus benchmarks, and am aware of a number of funds that have gone down this route. I wouldn’t rule it out in the future if we felt that was the right approach.” At West Midlands, Drever said that when it comes to fixed income benchmarks, a lot depends on what an investor is trying to achieve. “The disadvantage of market cap benchmarks in fixed interest is that they can skew investment towards bigger and higher risk issuers. Add in the current low yield environment and the case for looking at alternative approaches, notably absolute return benchmarks, is strong,” she said.
The Bedfordshire Pension Fund has increased its use of absolute return fixed interest, according to head of pensions Geoff Reader. The absolute return fixed income allocation is just under half of the fund’s 18% overall fixed income allocation. On benchmarks, Reader commented: “For active management in absolute return fixed interest, a cash-based benchmark is best. For passive fixed interest, a market-based benchmark is required.” An absolute return fixed income mandate gives bond managers greater discretion over using different sub-categories of the fixed income market, such as convertibles, direct lending or emerging market debt. Commenting on the overall patter of risk and return in fixed income markets, Reader said: “The current level of yield and implied risk is being examined by the fund to see if it warrants any change to its passive fixed interest holdings.”
From a fixed income manager perspective, MSIM’s Ford said that it is his impression that active fixed income strategies have outperformed passive strategies over the last five years. Ford added: “Most active managers have overweighted risk assets because credit spreads have been attractive.” This is in addition to the fact that whereas equity indices are dominated by companies with the largest market capitalisation, bond indices are tilted to those institutions issuing the most debt. Ford asked: “Going forward a key question is do you want to own all the issuers in an index to maximise the return or a selected sub-set. Our view is that owning an issuer because it has the most debt, and hence a large weight in an index, is not sufficient to maximise returns.”
In the future, fixed income will play an increasingly important role at many local authority pension funds, especially as they move from being cash flow positive to cash flow negative. In this position, holding income-producing assets and carefully managing key risks will be a central goal for investment staff. To do this, we can expect to see local authority funds using a wider range of fixed income assets and investment approaches than in the past.