Quest for holy grail

Under increasing pressure to match their liabilities with their assets, schemes are looking outside traditional sources of stable returns like bonds to alternatives that can offer similar characteristics, such as property.

Demand for bond-based liability-driven investment strategies has sapped the supply of gilts, pushing up prices and driving down yields. Some pension funds are using property as a proxy for long-dated fixed income in their LDI portfolios.

BDO Stoy Hayward Investment Management’s chief investment officer Shaun Port explains the trend: “Trustees have long been searching for the holy grail of investment – a stable and predictable income combined with the potential for capital growth.

“Commercial property in particular has the ability to satisfy the first objective with a similar volatility profile to bonds, but it does not offer the certainty of capital gain. In the UK in particular the significant yield compression experienced over the past three years would suggest that limited potential for capital growth presently exists, unless investing in an actively managed fund or in assets with a strong potential for rental growth.

“The result is that the continuing weight of money being invested in this area will either need to move up the risk scale or run the risk of being disappointed.”

Arlington Securities head of investment strategy Andrew Smith says the investment characteristics of property, which are similar to those exhibited by long-dated bond investment, are important for pension schemes primarily because of the relative predictability and durability of the income streams, and also because of the decreased volatility they display compared to bonds.

He explains: “Income generation from UK real estate is a good match for both inflation and earnings. The credit risk associated with property occupiers is also often of a good quality that, subject to break clauses (most leases are around 15 years long), could be viewed in a similar way to bond credit ratings.

“Of course, each property sector has different characteristics – the office sector, owing to its more pronounced development cycle, has a more volatile return profile.

“However, the sector returns are often cyclical, counteracting each other, and income return remains less volatile across all property sectors than in bond investment. Consequently, the asset class produces the required matching effects, albeit with slightly increased volatility over bond investments.”

Schroders’ head of strategic solutions Neil Walton believes investors are interested in property because of the inverted shape of the yield curve in the UK, where long-dated bonds yield significantly less than cash and short-dated instruments.

He says: “When expected future inflation is taken into account, the real rate of interest also shows a significantly inverted shape. The very low level of real yields, at least by historic standards, is leading pension schemes to consider other forms of long-dated inflation-linked assets. The income growth from UK property assets rises broadly in line with inflation and/or wages.”

As with any asset class, there are the usual positives and negatives that schemes should consider before investing in property, such as the potential return and risk profile. Yet when using property in place of bonds there are extra considerations, such as the volatility and liquidity of the assets, in addition to its growth potential.

Port points out that in the last three years a prerequisite of achieving a strong return from UK property was simply “turning up”.

However, he says, with prime yields compressed to historically low levels, above-average returns will come either from risk-taking activity such as development, rental growth or from actively managed funds looking to improve the quality of their assets.

He recommends that schemes choose funds that invest in physical property, rather than real estate investment trusts or securities funds: “Looking overseas presents interesting opportunities, but the main risk here is believing that investing in the proliferation of Reits and securities funds will provide the same risk characteristics as physical property. Excellent returns may well be achieved, especially compared to UK bond yields, but it will come with equity-like volatility rather than the profile associated with investment directly in the physical asset.”

Walton believes the main drawback of property as an asset class is not the same as an inflation-linked high quality bond, since the residual value of the property has “equity-like” characteristics.

He says: “We have reviewed the correlation between UK property and UK gilts and have seen periods of high correlation – property performing like bonds – and low or negative correlation where property has behaved much more equity-like.”
Smith says that property is attractive to pension schemes because it is less volatile than bonds, but has higher returns in the long term.

He says that market sensitivity advantages when dealing with property are often overlooked.

“When large pension schemes announce a strategy shift to LDI investment, the increased demand can have an effect on bond pricing, making them more expensive. Consequently, schemes often manage these changes anonymously over a period of time in order to minimise the effect on the market, enabling them to achieve more advantageous pricing.”

But, Smith continues, such concerns do not exist within property investment, as the market is far less sensitive.

“A further example of this is bond pricing, which reacts ahead of interest rate changes, whereas the property market, while aware, lags behind. This may minimise short-term arbitrage opportunities, but it does mean that any transition does not need to be managed so sensitively.

“Indeed the asset class has behaved much more like a short duration asset over the last 30 years, which is demonstrated by its insensitivity to interest rate movements.”

Earlier this year Professional Pensions reported a concern in the industry that schemes will fail to match liabilities properly if they use property as a proxy for bonds in their LDI strategies.

And despite the advantages of property investment, Walton agrees there is a danger of this happening.

He says: “Property has a role in diversified portfolios where risk is measured relative to pension scheme liabilities and in the long term, the inflation-linked characteristics of rental income makes property attractive.

“The key factor is that property returns are largely driven by changes in market rental growth, which is determined to a large extent by economic and business activity. There is a significant positive correlation between both property total returns and rental growth, and also between GDP growth and total returns.

“This view of property puts it firmly in the growth/equity/risky assets camp.”

Port adds: “Highly leveraged property investments can lead to a distinct duration mismatch, while exposure to property securities that offer a tempting taste of exposure to overseas property have a risk profile more akin to equities than direct property.”

Smith points out it is important to remember that LDI portfolios are also structured to exceed liability requirements.
He explains: “The ability to generate alpha in a property portfolio is possibly higher today than ever before.

“The emergence of the niche sectors such as student accommodation as well as the increasing number of investment grade opportunities available in Europe has expanded the opportunity set for investors.

“This enables them to seek continued added returns when market pricing in more traditional areas is starting to look less favourable.”

Lane Clark and Peacock’s associate consultant Mara Carter points out property has an attractive income generating profile for pension funds, producing long-term real returns which have tended to be higher than those provided by bonds.

She continues: “As UK property yields have fallen, trustees have turned towards the wider global opportunity set, in particular the European property market, as a means of diversification and yield enhancement.

“On the downside, over short periods at least, property is unlikely to respond to interest rate changes in the same way as bonds, thus creating potential funding level volatility. In addition, as pension funds increasingly access non-UK property, currency risk will become more of an issue for this asset class.”

Emerging market debt
As well as property, pension funds are turning to other assets like emerging market debt as they seek alternative ways to match their liabilities.

Port says pension funds are interested in emerging market debt because UK bond yields have remained obstinately low, so it is tempting for schemes to seek higher yielding bond investment from overseas markets.

He explains: “The higher yields offered by overseas markets in a compressed G7 yield environment, together with improved emerging market government credit ratings have all boosted the popularity of this asset class. Moreover, less developed overseas markets give far greater scope for a smart bond manager to add real value, especially compared to the UK environment.

“While non-sterling bond investment clearly opens up currency risk, in an environment where the consensus is for long-term dollar weakness, anticipated currency gains may be a positive attraction.”

Ashmore Investment Management’s head of research Jerome Booth says the question is not why pension funds have suddenly seized on these assets as a good thing, but rather why they have not utilised them in the past. He says it is simply because schemes were not aware of the assets, let alone their matching potential.

He explains: “Funds were not aware of the asset class’s potential for significant risk reduction and return enhancement and that it is a market much larger and more liquid than the FTSE100 to boot.

“Emerging debt is now accepted as a strategic fixed income allocation, and one moreover requiring specialist management.

“Different pension fund systems have come to this conclusion at different times. The Dutch moved early, the US public funds started to allocate in serious volume in 2001/2002 and this year Germany, the UK and Japan are seeing significant allocations begin.”



As UK schemes embrace this alternative liability matching strategy – what are the benefits that are enticing them?
Booth backs the strategy saying the primary way to match future liabilities is to have a bigger pool of assets – i.e. to generate returns – and the second means is to ensure that one does not risk suffering major investment losses.

He explains: “This may mean avoiding concentration and doing something about the two major sources of risk for most pensions – the home country bias and the equity bias.

“Emerging debt can both increase return and reduce risk significantly, and I cannot think of any significant drawbacks that stand up to rational scrutiny.”

Despite Booth’s approval of the asset class, Port does not agree.

He says: “Emerging market debt will move outside the usual cycle of G7 economies. While this is good news from a diversification point of view, it reduces the attractiveness of the investment from an LDI perspective, given that liabilities will move in line with UK bond yields.

“Finding debt instruments of a suitable term may also be difficult. Managing debt investments on a cyclical basis, depending on the global environment, rather than a buy-and-hold asset allocation policy, may help.”

Investec Asset Management’s emerging market debt portfolio manager Peter Eerdmans agrees the emerging debt markets can offer good value, but says given the wide range of markets and valuations, local pension funds should always consider valuations in their specific market.

He explains: “As long-dated bonds are still quite rare, they are sometimes priced expensively relative to the rest of the curve.

“This could advocate a more diversified approach including shorter-dated paper. In addition, pension funds should try to hedge their inflation risks more specifically, as nominal bonds will not always price in enough inflation risk premium.

“A number of emerging countries have started to issue inflation-linked bonds which provide a good alternative to nominal bonds. But also investments in diversifying asset categories either in local equities or global asset classes should be considered.”

Despite their traditional domestic bias, UK pension funds should not be ignoring emerging market debt as an asset class Booth says.

He declares: “The home country bias is at a real cost in risk adjusted returns. If a pension fund only invests in local property and is in an earthquake zone we would not think it sensible.

“A pension fund needs to justify why it would not invest overseas, not the other way round. Emerging markets have over 80pc of the world’s population – what is the excuse for not investing there?”

Port advocates investing overseas not for diversification reasons, but as a good way to increase returns.

He says: “The higher yields on emerging market debt are due in part to lower liquidity, which should not be an immediate concern of the longer-term investor.

“In our view the most interesting investment in this sector is local currency denominated government debt, where markets are less developed and less liquid but offer rich rewards.”

Infrastructure
A relative newcomer to the market is infrastructure, which offers long-term assets like roads, ports and hospitals with a longer maturity than government or corporate bonds.

A report issued by property investment specialist RREEF last year said schemes are recognising that investing in privatisation programmes or public private partnerships provides stable returns over a long period – a much closer match to liabilities than other asset classes.

The report said: “Investors, particularly pension funds, are showing an increased interest for infrastructure investments, attracted by characteristics like long maturity and high, stable income-orientated returns as well as the opportunity to diversify from traditional asset classes.”

It added that infrastructure income is usually government-backed and enjoys a strong competitive advantage due to low counter-party risk and monopoly positions.

Henderson Global Investors’ director of institutional business Michael Cox says: “Broadly speaking, the asset returns in infrastructure are stable, non-volatile and are not GDP-sensitive.

“These characteristics have considerable appeal to pension fund trustees in helping to match their long-term liabilities, particularly at a time when the availability of long-term bonds is so scarce and their values are considered a little expensive.”

Walton adds: “The diversification benefits and reduced volatility compared to equities is also seen as a positive. Often the infrastructure assets are relatively insensitive to economic conditions, as demand is stable. The increasing ability to access infrastructure through fund structures is a factor behind the growing popularity of this asset class.”

Like property and emerging debt, infrastructure is used as a way to introduce some diversity into an investment portfolio, but it also has its drawbacks.

Walton says the key benefit of infrastructure is the long-term, inflation-linked (often by regulation) income stream that mature infrastructure projects can deliver.

He says: “This income stream compares favourably with current yields on long-dated gilts.

“The downside is that the yield pick-up is not risk free and the liquidity of the investment may be limited. In a similar way to private equity, the fee structure within infrastructure funds requires work to fully understand and determine if it is appropriate.”

Also, he says the returns from infrastructure are not as high as they could be.

“Although the potential infrastructure market is very large, the strong flow from institutional investors has impacted pricing for infrastructure assets, thus lowering future expected returns.”



However, Cox argues that infrastructure can be said to offer superior returns to equities, and, being lowly correlated to both equities and bonds, it offers good diversification too.

He expands: “Following the equity collapses of recent years, and their immediate adverse effect on pension fund values and sponsor balance sheets, there has been a major search for such areas of diversification and return.

“However, access to the asset class is via closed end vehicles, typically up to a 10-year life, so the products are illiquid; furthermore, the products have no history or track record.”

Carter adds: “Infrastructure is similar to property in many ways due to its stable, long-term, real return generating capacity. While infrastructure offered very attractive returns to early investors, growing interest in the asset class has had an impact on the return profile, with some suggesting the development of an infrastructure bubble, at least within certain market segments.

“Deals and funds are often highly geared and typically illiquid. As with property, over the shorter term, it is likely that infrastructure investment valuations will respond differently to interest rates changes than bonds, thus impairing the matching characteristics. This may be accentuated by the debt structure within a given project.”

As with emerging market debt, there is a risk that schemes will fail to match liabilities properly if they use infrastructure as a proxy for bonds in their LDI strategies.

Cox says: “Currently those pension funds who have purchased infrastructure have made only a modest allocation versus their bonds, which still remain the core investment within their LDI or strategic benchmark. Infrastructure is still perceived as relatively high risk and only has an appropriate modest weighting at this stage.”

Walton adds: “Risks remain in LDI strategies that involve infrastructure. Certain infrastructure assets have long-dated bond characteristics; however, these assets are not bonds and thus should be used in broad LDI strategies as one source of return in a well diversified approach.”

Port sums up: “There is a risk most notably because some infrastructure investments will look more like equity investment than bond investment.

“However, as part of a well-diversified investment strategy, infrastructure investment clearly has a useful role.”