Newton Investment Management’s Mark Hammond considers the case for including absolute-return bond strategies in DC default strategies
The extraordinary current investment backdrop is causing debate over the appropriateness of various traditional asset classes within defined-contribution (DC) default structures, bonds being perhaps the most intriguing of these. There has never before been a period when so much of the government bond universe has been trading at negative yields. Lenders to government entities have traditionally received fixed, positive rates of interest, but such is the perceived risk associated with other assets that investors in some maturities of some sovereign bonds now have to pay for the privilege of keeping their money safe in this traditionally risk-free investment.
With increasing signs that the global economy is entering a more challenging period, it seems likely we may see further falls in rates and more bonds moving into negative-rate territory. Once a bond has a negative yield, the only way to make money (in nominal terms at least) is to sell it at a lower yield before rates start to rise and the capital value falls. This sort of short-term trading mentality is not something that most pension fund participants would traditionally associate with bond investment.
Deploying an absolute return bond strategy is one way to gain exposure to bonds while seeking to mitigate the short-term implications of negative rates. Indeed, there is a strong argument that absolute-return strategies could be a more appropriate way for DC schemes to invest in bonds in all environments, and several of our clients have adopted this policy. Defined benefit (DB) schemes have to deal with the ‘asset versus liability' equation in a somewhat different way from their DC counterparts. For a DB scheme, if bond yields fall and therefore, mathematically, asset values rise, there is a corresponding increase in liabilities, owing to the requirement to provide a fixed level of income from a certain amount of money. This automatic ‘matching' mechanism does not apply in the same way to DC schemes. The liabilities for a DC scheme are really the individual cash requirements of DC members, which have a closer link with inflation rates.
Investing in strategies that target an absolute rate of return could therefore be a better match for DC schemes, as long as the strategy selected genuinely has the capacity to generate its target return in a range of market environments. A focus on diversification is especially relevant, with the ability to assess elements like credit quality and geographic exposure. Such an approach should help to avoid exposing DC investors to the guaranteed negative returns associated with some government bonds, while providing the relative safety associated with bond investment over the long term. It can be used as part of a traditional default lifestyle solution as members near retirement, but can also aim to offer both downside protection and risk-adjusted returns for savers who continue to seek low-volatility capital preservation ‘through retirement'. Looking to the future, we believe that higher-yielding variations of absolute-return bond strategies will increasingly feature within post-retirement solutions.
By Mark Hammond, head of institutional pooled funds, Newton Investment Management
Important information: This is a financial promotion. This article is for professional investors only. These opinions should not be construed as investment or any other advice and are subject to change. This article is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those countries or sectors. Issued in the UK by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorised and regulated by the Financial Conduct Authority, 12 Endeavour Square, London, E20 1JN.