Pension funds slicing up bond allocations between managers

The US credit downgrade by Standard & Poor’s has underscored the deterioration in parts of the fixed income market. Many investors have been diversifying away from dollar debt in recent years and the downgrade may speed up this process.

However, there is still open confidence in the US and it is viewed as one of the safest investments in the world. It is, essentially, a minor blip – especially when viewed in the context of the current carnage in the European sovereign debt market.

Uncertainty has become rife. Greece, Ireland and Portugal are junk; France is tipped to be downgraded but not before Spain  oh, and let’s not forget Italy.

Slicing up bond allocations between managers has snowballed among pension schemes in the UK. This practice mitigates being caught out by having many investments in one area  for instance, in the eurozone.

Instead of having one manager looking after the entire bond allocation, the scheme may have for example one manager for UK index-linked gilts and another for emerging market debt.

Pension schemes that had invested in one passive bond mandate in the past may have suffered as these funds are slow to react to problems in the market and may have been heavily invested in one region or type of debt. Schemes are now looking for a selection of active managers.

The most recent example of this is The London Borough of Waltham Forest Pension Fund appointing Wellington Management for a £70m active bond mandate.

So, why have approaches towards fixed income changed and what are the benefits of splitting up bond mandates?

The fixed income strategy of old

For the average UK pension scheme ten or 15 years ago, the fixed income area of the portfolio was perceived as being slightly dull and unexciting.

Traditionally, schemes had balanced mandates that allocated 50% to bonds and 50% to equities, and used one or two managers.

Attitude towards equities started to shift and people began to pay more attention to them, investors began to diversify out of UK equities and saw more global opportunities.

Even so, people still viewed bonds as bonds and this would mean that not much happened in the way of diversification to this part of the portfolio.

The bond allocation would have been made up of a few gilts, some index-linked bonds and a smidgen of credit. It was traditionally seen as the defensive section of a portfolio (a way to limit risk, preserve principal and minimise volatility).

The biggest driver for change in the fixed income market was the credit crisis in 2008. Simple, balanced mandates became increasingly rare and according to L&G head of institutional fixed income sales Malcolm White, the crisis solidified the change in attitude towards bond allocation.

“Diversification is just as important in the bond market as it is in the equity markets,” says White.

“So there has been this stratification, not just to specialist managers but various pockets of expertise, be it investment grade, high yield, emerging markets and so on.”

He also believes that manager risk was an area that pension schemes became acutely aware of and there was a push to reduce this risk.

“What the crisis showed is that if a pension fund had 50% of assets in fixed income with one manager and they got it wrong the pension fund suffered,” adds White.

A change in philosophy

This aversion to manager risk had changed the philosophy of many pension schemes. After things became a little clearer and portfolios were retrenched, schemes started searching for managers with specific skills.

Questions were asked about certain managers. For instance, are managers of gilts good at managing credit or corporate bonds?

"There are different decisions to be made," says BlackRock managing director - fixed income strategy Dominic Pegler.

"One is about the directions of interest rates, the issues about the size of the deficit and impacts on gilt yields. In corporate bonds decisions are about what the certain credit qualities of a company will be."

This splitting down of managers means schemes can focus more on solutions to the specific problems they may also face.Fund managers are now trying to offer bespoke solutions to fit the nuances of each pension scheme. J.P. Morgan Asset Management international chief investment officer fixed income Nick Gartside has seen this happening regularly and notes the change.

"The days of going to a client and saying ‘this is our UK aggregate bond fund' are over. There is now a big trend towards solutions.

Every client needs to be seen as different and there also needs to be an appreciation that every client has a different liability stream," he says.
What value can specialists offer?

Specialist managers will be more active and have better knowledge of the areas they are investing in.

"In certain asset classes you have small amounts of people that make more informed decisions very quickly, and you also need focused research," says Mercer principal Paul Cavalier.

Cardano UK cheif executive officer Kerrin Rosenberg is in agreement with these points and says that certain areas of the market become compelling at times and there needs to be a degree of flexibility.

"Many fixed income markets are fundamentally cyclical," he says.

"So you don't want to put 5% in the market and keep it forever. You need to decrease and increase with prospects and opportunities."

The biggest question raised with splitting out mandates is with regards to governance, Mercer's Cavalier notes this is mostly scheme specific.

"Some schemes have their own teams of individuals that are employed for this reason, but there is a cost associated with this, although this cost can be beneficial.

If these teams are good at asset allocation and paying attention to market dynamics then they can allocate even for short-term opportunities," he says.

With schemes that do not have sophisticated governance departments and a large budget, there is much reliance on consultants to explain how solutions are structured and what benefits they will have for the scheme.

Towers Watson senior investment consultant Mark Horne believes that communication and dialogue is key to finding out how much risk a scheme can tolerate.

"You work closely with clients, discuss the big picture and agree what we'd like to achieve. You have to explain to schemes that there are many ways things can be done; there are different viable solutions but all investors have a different tolerance to risk and complexity."

Specialist managers also do not come cheap but the defensive moniker on fixed income may not be justified or accurate anymore.

Many investors now also see the return seeking potential from fixed income and managers feel extra cost should reflect this.

"The higher performance type of mandates, for example global securities or high yield," says Pegler, "with the promise of additional return on performance justifies the extra cost in terms of fees."

JP Morgan's Gartside feels even with the extra cost associated with specialist managers, the cost is negated by the fact that schemes achieve a better match for assets to liabilities.

"You need to measure cost through this prism and where you do it is not really a factor."

Finally, the added impact of diversification of managers dampens the additional cost of managers.

"It's generally held that diversification is your friend. So if you build a well-diversified portfolio you can usually improve your risk-adjusted return," says Horne.