Fixed income & risk: muddying the waters

Christine Senior asks how pension funds can mix up their fixed income portfolios

Bonds are the backbone of a pension fund portfolio, providing stability and the certainties of cash flows to pay the pensions. But the structure of the bond portfolio is gradually changing. Given that many pension funds in Europe historically have held big allocations to bonds, and with evidence that some pension funds are gradually increasing their bond weightings at the same time as reducing their equities, pension funds must be committed to making their bonds work harder.

One way pension funds are achieving this is by giving fixed income managers freer rein to implement their best ideas and find value wherever and however they can. The benchmark is becoming less of a constraint.

Malcolm Jones, investment director of fixed income at Standard Life Investments, comments: “Maybe ten years ago you were allowed perhaps 10% freedom to invest off benchmark but it is more like 30-40% now and some managers have unconstrained mandates – they can invest in what they want to achieve their target.”

The freedom to invest in a wider range of assets takes two forms. The first is that managers with a domestic benchmark will be able to invest in overseas assets, and secondly they will invest in different types of assets. The traditional aggregate benchmark of government bonds and investment grade corporate bonds leaves limited freedom to vary allocations between the two. “Slowly guidelines have been widened,” says Jones. “So on the government side why just invest in fixed bonds when you can invest in inflation linked as well, and on the corporate side why restrict yourself to investment grade when you can invest in alternative types such as lower quality credit or high yield bonds?”

Another way that managers are stretching the boundaries is through the increasing use of derivatives. The use of derivatives in liability driven strategies for interest or inflation matching has increased interest and willingness among pension funds to contemplate using them in other areas. Derivatives open up the opportunities for fixed income managers to follow their instincts and implement their views, for instance by separating views on interest rates from views on currencies. “People realise that by using derivatives you can unbundle strategies,” says Keith Patton, head of fixed income, Europe at Aberdeen Asset Management. “We can now make a curve trade independent of a duration trade and a credit trade independent of a duration trade, so we could buy a 30 year maturity credit but hedge out all the interest rate risk.”

Traditional long only managers have been confined by the straitjacket of the benchmark. Once those chains are loosened, using derivative-led strategies allows better use to be made of the risk budget, allocating risk to those areas where it earns the best rewards.

Bond futures are one tool managers are using to express their views. Take for example a portfolio of eurozone bonds. This would leave little room for managers to express a conviction that Japan would outperform the US.

This is now changing says Dominic Pegler, head of fixed income strategy at BGI. “The trend we are seeing is to be able to put the view ‘Japan versus the US’ in the portfolio. You allow the bond manager to do a long/short type of investment – buy the market you like and sell the market you don’t like. Even if you don’t hold them in the first place you can do that if for example you use bond futures.”

The change of strategy has been gaining ground over the last few years, driven principally by (until recently) placid markets, which made adding value difficult.

A strategy advocated by Jean François Boulier, head of euro fixed income and credit at Credit Agricole Asset Management, is to play the yield curve. For him the basic starting point is a benchmark that represents the liabilities, then adding value by playing the curve. “We expect that interest rates at the short end of the curve will go down more quickly than longer term rates. We now have ten year rates in euro of 4.4% and two year rates below 4%. We see the curve steepening, and to manage the portfolio appropriately we will have more exposure to short term than long term duration. It means having an overweight in short term so that the average duration is even longer than the duration of the benchmark, because we feel central banks are no longer in a tightening cycle.”

Some pension funds may be wary of introducing more risk into their portfolio by giving managers more leeway to move away from the benchmark. Patton argues that in fact risk is being reduced, because the manager is taking many smaller positions and getting greater diversification.

Dutch pension funds are arguably some of the most clued up about using the more exotic strategies and instruments according to Pegler but, he says, this is probably a function of their size. “The structure of the Dutch pension fund market is one of relatively few big schemes and they tend to be most ready to espouse new ideas.”

But Boulier also points to recent interest from a Nordic pension fund in high yield credit. “It shows that mature investors even with conservative attitudes are able to exploit market opportunities. The asset class may be considered adventurous but it really depends on how big the allocation is.”

In the UK LDI is having the biggest influence on how pension funds structure their fixed income portfolios. Here trustees have moved further down the route of de-risking their liabilities.

Phil Barleggs, head of fixed income product management at Insight Investments says this is changing the face of a fixed income portfolio, by the introduction swap arrangements with investment banks. These are structured to deliver fixed cash flows to match liabilities in return for paying a floating rate to the bank.

“We have a number of LIBOR plus products which use the whole range of fixed income department skills for alpha generation. To generate LIBOR plus 2% in normal fixed income space is not possible in long only. Once in that space you need the ability to short and to use lot more exchange traded and OTC derivatives. It will have in it credit default swaps, it may have short positions in a number of different asset classes, it’s likely to have exposure to anything you have expertise in delivering returns from.”

A different view comes from Mark Parry, head of fixed income at Close Investments, who backs government bonds in the current climate. Investors use bonds in their portfolio, he says, to protect their capital as well as to get an income, so given the current uncertainties there is a lot to be said for the stability and predictability government bonds provide.
Over ten years the average outperformance of credit over UK government bonds has been half a percentage point, he says. “Not a very big number, when you consider the risks involved in that, particularly where we are in the economic and investment cycle,” he says. “I would suggest the clear cut case for always buying credit over governments is not as straight-forward as it might seem.”

Nevertheless Close takes an innovative, proactive approach to managing government bonds, by using call options on the bonds as a way of enhancing returns.

“In a rising market we’d like to fully participate in the move so we probably wouldn’t be very active in writing calls,” says Parry. “In a stable or falling market the strategy allows us to extract value by exchanging the uncertainty of future price movements for a guaranteed income in the form of the option premium, which we receive the next working day.”

Written by Christine Senior, a freelance journalist