Chasing Returns, hurdling risks

As trustees grapple with large deficits and a greater pressure to match assets to their scheme liabilities, they are increasingly turning to the bond market where they can find relatively stable incomes with low risk.

However, as the returns available from bonds have become more subdued in recent years due to the increased demand, schemes have placed more pressure on their fund managers to outperform the benchmark.

Aberdeen’s head of fixed income Charles McKenzie explains: “As fixed income allocations have increased, trustees have naturally started to look more closely at what their fixed income managers are delivering. And with most commentators expecting relatively subdued performance from financial assets over the next few years, they are increasingly demanding higher outperformance relative to benchmark.

“In the last decade, the average pension scheme’s allocation to fixed income has roughly doubled. The reasons for this have been well documented and include: the greater maturity of defined benefit schemes, the widespread replacement of balanced mandates operating against peer group benchmarks with scheme-specific benchmarks, and the introduction of accounting standards that link the present value of liabilities to corporate bond yields.”

Aon investment consultant and actuary Daniel Peters points out that over the last few years the corporate bond market has grown substantially, both in size and in sophistication, and the bond and credit derivative market has also expanded rapidly.

He says: “This means that while a few years ago a bond manager was limited to a narrow range of bonds that could be bought, a competent manager now has the ability to choose from a wide range of bonds, buying or selling interest rate and inflation swaps, and buying or selling credit default swaps and other derivatives.

“Some of these ideas have been around for a long time – swaps have been used ever since 1981 when IBM and the World Bank entered into the first large scale swap deal.

“However, what has changed is that the investment management industry has now developed funds suitable for pension schemes that enable schemes to invest in these strategies in a simple manner.”

Prudential M&G’s head of institutional portfolio management David Lloyd disagrees with McKenzie, saying the bond market is still providing robust returns and looks set to continue to do so in the future.

He argues that upbeat economic growth and an uptick in inflation have prompted the Bank of England to increase base rates to the highest level since August 2001. In response, yields on short dated bonds have risen fairly sharply since mid December, to currently stand at around 5.5pc.

Lloyd adds: “In contrast, demand for long-dated securities – particularly index-linked – has been relatively robust, prompting the yield curve to remain significantly inverted.

“Corporate bonds continue to defy widespread expectations of under­performance, and the recent weakness of this market – prompted by February’s sharp falls in global equity markets and concerns over the sub-prime mortgage sector in the US – has proved short-lived.”

Yet Lane Clark & Peacock partner James Trask says the market is failing to provide the large returns schemes want – and it is unlikely it will in the near future, as bond yields are languishing around 4-5pc.

He explains: “The yields are pretty much anchored between their lowest level – close to 4pc – and you can’t find bond managers that like it enough to go above 5pc. So it’s moving up and down within a small range and the longer-dated yields are much lower than short-dated yields. I think that is going to persist because it’s driven by demand from pension funds.”

The new demands from LDI
Bonds have traditionally been used to match liabilities safely, gaining a smaller return in return for lower risk, but the structure of bond mandates is changing. They are no longer just used as an asset matcher – with skill and the right tools they can also be used to target growth and manage risk in the portfolio.

McKenzie says schemes have realised they need the freedom to invest in the full spectrum of the bond market in order to generate returns from a wide range of sources without a significant increase in risk.

He explains: “There is a growing recognition that to achieve consistent strong returns in the current environment, investment parameters need to be widened to capture alpha opportunities that are available elsewhere in the world.

“For instance, by investing in global investment grade credit, we are able to take advantage of mispricing anomalies that exist. Through the use of derivatives we are then able to hedge out any unwanted interest rate and currency risks in overseas credit. We also have the flexibility to then hedge back to the client’s required benchmark, which may be liability rather than benchmark-driven, therefore creating the desired beta.”

Trask says pension funds have been struggling to outperform their benchmarks because of a lack of volatility in the bond market. He says this has created an environment where it is difficult for managers to take risks that will pay off when there is little movement to take a risk on.

He explains: “Nothing much is happening in the bond markets and it’s quite difficult for an asset manager to take bets that actually pay off.

“To deal with this you can ask the bond manager to take charge of that, whereby he’s doing the same thing as before, but doing it more aggressively, which has some risks.

“However, I think we are seeing more innovation from bond managers, particularly in the use of CDSs and the ability to go short as opposed to not holding a bond at all. So, managers have a little bit more freedom.”

Lloyd agrees that innovation has become a feature of the market in the last few years, where schemes have sought to match their liabilities in the most efficient and advantageous manner.

He says: “Pension funds are fast coming to realise that some of the assets they currently hold, such as equities, do not match their liabilities and therefore are taking steps to make necessary changes to their portfolios.

“The traditional approach to cashflow matching investment is to utilise UK gilts, broadly diversified investment grade corporate bonds, and swaps.

“However, non-traditional credit assets can also be used in an LDI-type offering. This enhanced approach incorporates the use of different fixed income asset classes and solutions to diversify risks. It includes the use of leveraged loans, structured credit, private placements and asset backed securities.”

But, as Peters points out, bonds have not entirely lost their traditional function as a means of reducing risk in a portfolio. He says schemes are still using bonds to protect them against the risk that interest rates might fall and the value of their liabilities increase.

He says: “In such a case swaps can often provide a useful tool to construct an asset portfolio that will increase in value as interest rates fall to match the corresponding increase in liabilities.”

Trends in bond allocation
Despite the prevailing pessimism surrounding the ability of the bond market to deliver decent returns, bonds are still proving popular with schemes.

Earlier this year, research by Aon Consulting showed that almost a third of pension funds reallocated over 5pc of their investment portfolio to bonds during 2006.

According to the research, 14pc of schemes have invested to diversify their growth assets over the past year, with the intention of being less exposed to a single volatile asset class. The greatest shift in 2006 was the continued return to favour of the property sector, with 50pc of schemes diversifying growth assets using property.

However, absolute return vehicles such as hedge funds (17pc) and global tactical asset allocation (11pc) are also becoming popular forms of growth investments, while 11pc of employers indicated that their schemes have adopted some form of LDI strategy in the past 12 months.

Peters says the reallocation to bonds is a common feature in pension portfolios, as funds seek to match their liabilities.

He says: “The increased volatility in markets over 2006 and the continued focus on bond yields has meant that the priority for many UK employers sponsoring DB schemes has not just been about assets, but on how those assets relate to scheme liabilities.

“There is also a growing focus on the relationship between assets and liabilities as schemes mature.”

McKenzie agrees there has been an increased interest in fixed income capabilities, both from new and existing clients.
He says: “There is a trend towards core plus strategies (i.e. making your fixed income assets work hard in terms of generating returns). We’re also seeing clients increase their fixed income exposure as part of an overall LDI solution.”

In contrast, Trask says schemes are basing their decision to switch from equities to bonds on performance criteria; only when equity doesn’t perform do they make the switch.

He explains: “What we’re seeing a number of clients doing is investing in alternative asset classes, rather than continuously switching into bonds.

“By making an allocation to an alternative asset class, maybe they’ll achieve similar results, in terms of keeping risk levels down, than you would have achieved by switching into bonds. And you would also get a higher return.”

Peters says the results of the survey are not surprising, as a typical investment strategy will often involve a scheme investing in bonds to broadly match the value of the liabilities in respect of pensioners, and equities or other growth assets to match the active and deferred liabilities.

Schemes will therefore typically move into bonds for two reasons.

He says: “The scheme may be maturing and the proportion of pensioner liabilities is increasing (a trend that is being witnessed across the industry). So, to continue to match the pensioners with bonds the scheme will need to increase the bond allocation.

“Alternatively, the trustees and/or the sponsoring employer may be seeking to de-risk and move out of equities due to the short-term volatility. Moving into bonds can provide a greater level of short-term stability as well as also protection against falling interest rates.”

Trask agrees the results are not unusual, but says the reason behind the switch is more to do with Pension Protection Fund regulations, rather than liability matching.

He explains: “Switching to bonds has been a feature every year, pretty much since the minimum funding requirement was introduced, which indirectly encouraged schemes to invest in bonds.

“There are companies that can afford to do it because they have small deficits and for whom switching into bonds is affordable. But there are others for whom switching into bonds isn’t affordable, or only to a limited extent, because if they do they’ll only be crystallising a large deficit they can’t afford to remove with contributions.

“They have to look for ways to try to maintain their investment return, while reducing the risk and that is where alternative asset classes may be coming in.”

Property as an alternative
Another factor having an effect on scheme bond allocations is the strong domestic property market.

Trask explains that property sits somewhere between equities and bonds in terms of their risk/return profiles, but in most cases it would be viewed as a diversifier to equities rather than as an alternative to bonds.

He says: “What we are seeing is UK property returns being very, very strong. Although a couple of years ago people were saying the bubble was about to burst, we’re still seeing good returns.”

Peters adds: “Many schemes would like to remove more of the risk in their investment strategies by moving out of equities.

“However, trustees may have reservations about alternative assets and may be reluctant to move into bonds because of the expected lower level of long-term returns. Property can offer a valuable substitute because it has bond-like features in that it provides a stable income stream, (and therefore has some interest rate sensitivity), and can also provide capital growth in a similar way to equities.

“Importantly, property also tends to be less volatile than equities. The view of the scheme actuary is also important in this context because the investment assumptions made for the purposes of the actuarial valuation can be a key driver of contribution rates for the employer and employees.”

However, McKenzie does not agree property is siphoning off investment that might otherwise go into bonds, saying: “Schemes are looking at a range of asset classes, including property, to enhance returns and to provide income.

“I don’t believe this trend is significantly affecting allocations to bonds – as long as fixed income investment managers can prove they have the experience, the range of capabilities and the track record to provide the enhanced returns schemes are now expecting.”

Looking ahead
Following a year where total returns for the major UK bond indices were close to zero, can there be any hope for the bond market in the next 12 months?

McKenzie believes there is, as the conditions that affected the market last year are no longer as influential.

He says: “Last year’s performance reflected both domestic and international factors, as economic growth turned out to be not as weak as some had feared, and official interest rates were raised in the UK, US, eurozone and Japan. But while bonds appeared to be expensive this time last year, and we were short on duration in portfolios to reflect that view, they are now much closer to fair value – as a result of the increase in yields.

“Performance of fixed income markets should, therefore, be better this year than last.”

Lloyd believes that with another rates rise, the housing market and consumer spending will cool, leading to increased returns on short-dated bonds. But he does not expect the corporate bond market to be overly affected.

He explains: “We anticipate that the Bank of England will raise rates again in the second quarter to 5.5pc, after which a significant improvement in the path of inflation is likely to keep rates on hold – perhaps over the balance of the year.

“Once rates have peaked, we would expect short-dated bonds to find support, leading to some modest reversal of yield curve inversion.

“In longer-dated securities, we do not anticipate a strong directional trend without an unexpected re-rating of growth/inflation prospects – either in the UK or globally. Our central expectation of trend growth and stable interest rates is likely to provide a benign background for corporate bonds, while an environment of receding inflation concerns is consistent with index-linked gilts struggling to continue outperforming their conventional counterparts.”

Trask also believes there will be little change in the corporate bond market over the next year, unless there is a big pick-up in default rates.

The latter, he says: “might cause a rapid widening of the spreads of corporate bonds over gilts, particularly now there are a number of positions taken in CDSs – which effectively gears up the credit market. When it happens, that widening might be quicker than in the past, but I don’t see it happening in the next year or so.”

As Aon’s survey highlighted, interest in LDI strategies was significant over 2006, although implementation has so far been relatively low.

Peters expects the interest schemes have shown to be converted into implementation, especially if there is an increase in bond yields – thereby making these strategies cheaper.

However, he points out: “If bond yields were to increase, the demand from pension schemes could well swamp the supply, and drive yields back down to their current low levels again.”