UK - Pension schemes adopting a passive approach to corporate bond investment could be exposing themselves to more risk.
This means that many schemes could be heading for a fall when it comes to FRS17. The controversial accounting standard measures a scheme’s liabilities in terms of long dated AA rated corporate bonds.
Passive funds are passive about stock selection and risk, according to Britannic Asset Management.
Fiona Ross, Britannic’s head of segregated funds, said: “If a fund is trying to immunise itself against future liabilities in line with FRS17, then it is trying to match them with AA rated corporate bonds.
“The problem with a passive bond portfolio that tracks an index is that it assumes the AA rated bonds bought on day one will always remain the same grade. This is far from the case due to downgrades.”
The number of downgrades has been increasing in the current environment as the financial strength of many companies has deteriorated, particularly in the US. Standard & Poor’s statistics show that only 70% of AA rated bonds are still likely to be AA rated in three years time, with only 1.46% likely to be upgraded to AAA. And according to Bloomberg Analytics, the market price of a corporate bond that is downgraded from AA to A falls by an average of 4.14%.
Bond issues by companies such as Tesco, Thames Water and Scottish Mutual are some high profile examples of AA rated bonds in the UK to have suffered a downgrade.
But pension schemes are less at risk when it comes to defaults since the actual ‘cost’ to a diversified portfolio that only holds investment grade bonds – as most pension schemes will do - is considerably lower than some figures suggest. Statistics show that default rates reached 3.7% for corporate bonds last year according to Moody’s. However, this is the figure for all corporate bonds. The chance of an investment grade bond defaulting is only 0.17% according to Moody’s .
Nevertheless, even though a passive portfolio could be instructed to sell a bond immediately it is downgraded and replace it with other AA bonds, this still locks in a loss, explained Britannic.
“Active management aims to spot potential transition stocks in advance. By picking the winners and avoiding the losers - both in terms of transition and default - active managers don’t just have the flexibility to outperform, they are also in a position to better match FRS17 requirements,” added Ross.
“The question I would put to those funds trying to operate within an FRS17 environment is can you really afford to go down the passive route?”
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