A falling average quality of fixed income indices combined with intensifying competition for high-quality assets could make it more challenging and costly for pension funds using benchmarks.
More than $1trn of corporate issues have been downgraded since the start of Covid-19, AXA Investment Managers said, leaving high-quality assets in short supply while demand is rising.
Over the last two years, high-profile issues including General Electric, Heathrow (Class A), HSBC (subordinated) and Wells Fargo (subordinated) have been downgraded and quit high-quality sterling indices, buy and maintain credit portfolio manager Simon Baxter noted.
Now, the top ten issuers make up more than 32% of the 15-plus-year index market value, while half of the index is comprised of just 21 issuers.
AXA IM warned that passive investors and the broader UK pension fund industry now faced a "difficult environment" while navigating large fixed income index rebalancings as issuers are downgraded.
"The ultra-low interest rate environment since 2015 has provided corporate treasurers with a strong incentive to increase the overall level of indebtedness in capital structures," Baxter commented. "This has resulted in a drop in the average credit quality of issuers, driving a large increase in the BBB component of credit indices, which now averages around 50% of the main credit indices."
Credit downgrades have largely been issuer- and sector-specific, he noted, but overall higher-quality sectors, such as housing associations, are now representing an increasingly large percentage of the longer-dated sterling credit indices. Noting the correlation within the industry and the ratings linkage with the UK sovereign, he said this could be a worrying trend.
"For the UK pension fund industry, which is particularly reliant on the higher quality, 10-plus-year and 15-plus-year A to AAA indices, this presents a serious challenge and comes at a time when there is increasing demand for high-quality long-dated assets.
"Plans are increasingly putting cashflow-generating solutions in place, and there are more investors chasing less available, high-quality assets. The ability to source these rare assets, at the right price, remains key to achieving portfolio goals."
Investors passively following a benchmark approach may find the market increasingly concentrated, challenging, and costly to navigate, he concluded.
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