Fixed income roundtable: adapting to new opportunities
Written by European Pensions team
Chairman and Panel
Chairman: Ian Maybury, Senior Actuary and Co-Head of ALM & Investment Strategy, Redington
Ian is responsible for co-managing the firm’s quantitative analysts and driving innovative client solutions. In his previous role at Citigroup, he established a centre of excellence in insurance ALM, risk and capital management. He also has a track record of building portfolios of clients across various jurisdictions in the UK, Europe and Asia and has a wide range of experience as a trustee of pension schemes both at Citigroup and Royal London.
Bernard Abrahamsen, Head of Institutional Sales and Distribution, M&G Investments
Bernard joined M&G in 2002 as a director of fixed income in the institutional fixed income team. His primary focus is developing the institutional bond business in the UK and Europe. Prior to joining M&G, Bernard worked for Schroders Investment Management where he was a director, responsible for the development of their Sterling fixed income business.
Richard Dryer, Head of EMEA Credit and Global Credit Product, Aberdeen Asset Management
Richard joined Aberdeen in 2009 following the acquisition of certain asset management businesses from Credit Suisse Asset Management. At Credit Suisse he was the head of European and UK fixed income. Richard joined Credit Suisse from Insight Investment Management where he was head of UK institutional credit. Prior to that, Richard worked at Schroder Investment Management as a portfolio manager.
Chris Helyar, Partner, LCP
Chris joined LCP in 1994 after graduating with a first class honours degree in Mathematics from Durham University. As head of investment strategy, Chris has responsibility for developing and maintaining LCP's investment modelling tools, which are a key part of LCP’s approach to helping clients set their investment strategy.
He also researches fixed-income investment managers.
Ajith Nair, Investment Consultant, Investment Advisory, Pensions, KPMG LLP
Ajith is a consultant on KPMG’s corporate and trustee engagement teams, responsible for delivering advice on investment strategy, asset allocation, implementation as well as risk management. Ajith is also a member of the fixed income research team within KPMG Investment Advisory. Before joining KPMG in April 2010, Ajith worked as a portfolio manager for Al Madina Investments in Muscat, Oman.
Erwan Pirou, Consulting, Global Investment Practice, Aon Hewitt
Erwan joined Aon Hewitt's Investment Practice in 2007 and is a senior researcher within the global investment management team. His main role involves researching investment managers with a focus on fixed income, cash and liability driven investment (LDI). Prior to joining Aon Hewitt, Erwan worked at Barclays Wealth as a corporate credit analyst focusing on the telecom and utilities sectors.
Paul Syms, Senior Portfolio Manager, Hermes Fund Managers
Paul is a member of the government bond team at Hermes, specialising in conventional government bonds. His main role is to manage the gilt and international bond funds and he also acts as the alternate portfolio manager for the inflation-linked mandates. He joined Hermes in February 2006 having previously worked for six years at Scottish Widows Investment Partnership in a similar role.
Recent economic climate
Chairman Ian Maybury: What are your initial thoughts around the
key risks that are being faced from the current economic environment, both from rates and inflation, but also from a credit perspective?
Syms: At this stage of the economic cycle there are some challenges, certainly for conventional bonds. We are at ultra-low rates, we’ve had a large amount of quantitative easing pumped into the system, and we now seem to have inflation starting to pick up again. For G12 government bonds it’s been a changing environment over the last three or four years; we’ve gone from being a fairly safe risk-free asset to a riskier asset with the sovereign debt crisis in Europe, and there’s a lot more sovereign credit analysis required.
Maybury: Are you seeing these sorts of issues challenging people in terms of either their strategic allocation or, perhaps more importantly, their tactical allocation?
Helyar: Many trustees are worried about inflation. Although, the 5% pa cap on pension increase could actually be quite a saviour for pension schemes, particularly if there is a sustained bout of inflation coming through. Many trustees are however looking to see what they can do to try and hedge out those risks, whether it’s using inflation swaps, index-linked gilts, or some other inflation-linked assets.
Pirou: We also see some concern around interest rates, with interest rates being so low across the world. It’s certainly a risk for pension funds which are heavily invested in fixed income, and there’s no easy solution to that because a lot of schemes are invested in fixed income to hedge some of their liabilities.
Nair: As far as inflation is concerned, there are enough tools in fixed income, so you have to look at what strategy suits you best. Some of the solutions, like inflation-linked gilts and swaps, are probably expensive in the current environment, so you could be looking at alternative solutions like absolute return strategies, inflation linked corporate bonds, network rail bonds, long lease property and social housing. The other interesting observation coming out of the crisis is that there is probably still some sort of illiquidity premium in the markets and you have to think about ways to exploit that. The case for fixed income is very interesting in the current market.
Abrahamsen: It is quite interesting that just because inflation is higher than normal right now, it doesn’t mean that trustees haven’t previously been worried about inflation. It’s just that a brighter spotlight is now being focused, and all it really does is highlight the lack of assets to match those inflation-linked liabilities. That effectively causes the angst, that’s why we haven’t seen yields rise despite the issuance that there is, because there is this massive mismatch between supply and demand.
Helyar: There is another reason why demand from low risk bond assets has been high. Recently risk assets have actually performed
relatively well, so funding levels generally have improved. That’s encouraged many trustees to switch into buying bonds because they’re in a better position to reduce risk than they were three years ago, despite the relatively low bond yields.
Nair: And it’s also important to think: where’s the inflation coming from? What’s the short-term versus the medium-term view? We believe, that in the medium term it may not be as big an issue as it is in the
Another point to consider is global inflation. People are talking about food price inflation in emerging markets, and how that’s creating social unrest. Even with these issues, pension plans can look at diversifying their portfolios on a global basis. If you can have an active manager, or a broad global portfolio which can feed into the different cycles across the globe, you can probably exploit those diverse scenarios. You can create a strategy that is well diversified that you are not stuck in one economic or inflation cycle.
Pirou: It goes back to why you invest in fixed income in the first place; if you’re looking for return or if you’re looking at it as a hedge. If you’re looking for return it makes sense to be global and have the ability to invest in a number of markets – a number of fixed income sub asset classes. But in terms of hedging it’s probably quite dangerous to try to hedge some UK liabilities with US inflation or Euro inflation because you’ve got quite a big basis risk and you won’t be protected if there’s a spike in the UK.
Maybury: How are you seeing clients viewing their credit portfolio? Is there a definite drift towards treating it as growth, and looking at it as return-seeking?
Abrahamsen: In the first instance there’s been a huge shift in terms
of appreciating what fixed income actually means. The universe has broadened now quite substantially and I think the crisis has also
highlighted what many of us have known all along: not all fixed income assets are the same. It can be a combination of both growth and matching provided you are targeting the right area within fixed income deliberately in order to solve those specific problems.
Maybury: So what’s constraining the move away from traditional benchmarks to absolute return? Or is it being constrained, is there actually a significant move?
Nair: A lot of trustees understand that the big opportunities in fixed income are gone. Over the last two years most of the asset classes were coming back with stellar performances, so you were probably OK just hanging on to the traditional benchmarks, and if you had an indexed portfolio then you would’ve done well. But those opportunities are gone, and now there is a definite case for active management, where there are a lot of dislocations within the market and a good manager can exploit those dislocations. There is definitely a move to look beyond traditional benchmarks.
Syms: Over the last few years we’ve seen lots of opportunities where government and inflation-linked bonds have mispriced inflation risk. By simply passively hugging the benchmarks one cannot take advantage to add value and preserve capital. Post the Lehman’s crisis UK & US short dated real yields rose to over 4% and breakevens were negative.
Pirou: I agree there are lots of problems with existing benchmarks. For instance you may see a number of mandates from the customer excluding the sector or the area that’s done badly in the last year or two. So let’s say after the tech bubble you’re going to have a benchmark ex-telcos, after the financial crisis you’re going to have a benchmark ex-sub-financial. Effectively what you do is potentially miss all of the recovery just after the event by excluding the part of the benchmark that clients are worried about. It’s not necessarily a good way to get returns in the long term.
Abrahamsen: It’s important to remember that benchmarks do not pay liabilities – cash does. And so benchmarks are just a measurement tool. A benchmark will just measure our performance relative to that. Because we’re managing towards an end game, the pension fund might have a string of liabilities as each pension fund is different – different funding levels, different sponsor covenants. You can take that into consideration and therefore that’s how you come up with a custom benchmark.
Maybury: Regarding absolute return strategies, do we have robust enough reporting back to the clients to enable them to understand that relative risk and return?
Nair: I think it’s not just with reporting, it starts even before that. For example, when you talk about absolute return strategies there’s often confusion in the market – like what is absolute return? Is it really absolute return or are you getting beta somewhere in that return? We work with our clients to make sure that they understand the risk they are getting into.
Maybury: I just fear that we’re in danger of going into a situation with a range of asset classes that are perhaps not as well understood. Yes there’s value there but do we really understand as a trustee body, or as the various stakeholders, the risks that are being taken here as well as the return expectations?
Syms: Realistically it comes back to the shape of the government yield curve – when it is very steep – switching out of bonds into cash is quite penal due to the additional yield one gives up, but of course at the same time you
protect yourself from a rising yield environment. However, to then try and top up that loss of yield with an absolute return strategy you can’t do without taking risk. You either take credit risk or duration risk, because nothing is for free. It is important to understand this.
Abrahamsen: If you have your absolute return strategy but there
is risk relative to your so-called benchmark that’s what the asset manager might be focused on. But if that is the wrong side of the benchmark you still have no sight of what the implications are for the liabilities.
If the strategy and liabilities are both on the wrong side then effectively it is a double whammy effect. So it’s making sure that these strategies are actually joined up, understanding that if you are under-performing relative to a benchmark, the liability situation might have got worse as well. Then the trustee is left in an even worse position because most asset managers really don’t understand the potential impact that it may have on the liability side, because they are benchmarked against a particular index or other measurements.
Maybury: Looking forwards, there is a significant illiquidity premium available in a lot of markets that from a pension fund perspective wasn’t available in the days of cheap bank finance. There’s also a lot of potential social good that pension funds can do in terms of their SRI initiatives, such as providing financing for structured products – social housing for example.
I think pension funds and insurance companies are really the only investors that take advantage of all of those areas and the opportunity for illiquidity. However, are trustees really comfortable with taking that illiquidity? I think they should be but in practice I don’t see many strategies that allow for it explicitly.
Helyar: There are illiquid asset classes that are great long term investments in terms of matching the characteristics of the pension scheme liabilities. However, you do need to remember that very often the trustees and sponsor will have another objective in mind, which is to ultimately secure the liabilities with an insurance company. You need to be very careful of going into assets like social housing because they could potentially become a sticking point, five years down the line, if the trustees want to buy out the liabilities. Will the insurance companies be willing to take on those illiquid assets? If the insurance company is willing to take them on but there is no market for those assets, what value will be placed on them?
Nair: One asset class that’s worth mentioning is emerging market debt (EMD). If you look at the pension world, probably the clients have been reluctant to get into the emerging market space. One might argue that the hard currency bit is close to fair value, but there’s a definite case for EMD, especially in local currency debt and corporate bonds space.
If you look at the fundamentals, emerging markets have done extremely well in the last decade, their balance sheets are improving and they have made structural changes to make sure that mistakes of the past are not repeated easily.
Maybury: Is the size of the EMD market large enough to accommodate significant flows, not just from UK funds but from European and maybe US funds as well?
Abrahamsen: If you come back to inflation, very briefly, the UK index-linked market is 200bn, the demand for inflation linked assets from UK investors is 3trn. Linking it back to EMD, there is so much demand, and for derisking, that for the pension industry to move wholesale into one category or another is very difficult.
Dryer: We believe you’ve got to be more bottom up, you just can’t
do top down allocation. We certainly see value in EMD, high yield, ABS, etc. But there are an awful lot of risks in there and an awful lot of over-
valued assets. We’ve had a massive rally in EMD and across risk assets over the last two years, and by definition that leaves some of these assets looking over-valued.
We talk about EMD like it’s just one decision, but what do we mean by EMD? If you’re looking at South America as a more defensive play versus China, there are SRI issues. There are so many different decisions you’re making within EMD.
I think the danger is when you allow a manager to allocate to the asset class, and you don’t actually exercise some kind of control in terms of what they’re doing.
Maybury: One of my concerns with ABS is the extent to which the stakeholders – the trustees and the corporates – still see that as a tarnished asset class because of some of the issues that occurred as we moved into the credit crisis. Is that a concern, or are we seeing people becoming more comfortable because they’re working harder to understand the risks that they’re taking?
Abrahamsen: One has to draw the distinction between US ABS and European ABS. We’re talking about sub-prime in the US, that was a significant problem. We didn’t have anywhere near those problems in Europe. The fact that they had such a stable structure meant that this asset class was also leveraged and effectively pushed spreads wider, not necessarily the poor quality of the underlying assets. ABS certainly is an asset class that funds should be focusing on, and many already are, either within a wider credit mandate or in a bespoke ABS fund, because it provides a return with a given level of security over and above public bonds.
Nair: Another reason for this dislocation between US and Europe is the fact that US had schemes like TALF and a deeper investor base to speed up the recovery. So there is a definite opportunity for schemes to exploit the extra yield from market dislocation on a typically high quality asset class. The ABS portfolios could be part of Libor generators under LDI or used as plain return seeking assets.
Maybury: Are those clients still nervous about them?
Pirou: Certainly with the clients we’ve been talking to, we see a lot
of concern about ABS. I don’t know any clients that would be willing to allocate a dedicated ABS mandate. It makes more sense in a broad mandate where ABS can be part of the allocation. It’s really difficult to time the entry into these asset classes, and clearly for trustees it can take some time to make a decision, so it can be dangerous to allocate to a small subset of the fixed income asset classes unless you’ve got a good governance structure in place and are able to react quickly.
Helyar: With asset classes like ABS, trustees should be clear about the nature of the asset class and in particular, the asymmetric risk profile. Unlike equities, where it is easy to grasp conceptually what a mining company and what a telco company is, and equally if one drops 10% another one might go up 10%, in fixed income, some assets are very difficult to understand and they can fall significantly in value without the potential to get the doubling of value on the other side.
I also think that trustees need to be very clear why they are holding a particular type of fixed income asset – is it to match for the scheme’s liabilities, or is it part of the scheme’s growth assets. Certainly, some fixed income assets should not be regarded as low risk matching assets.
Maybury: That needs to be recognised by the trustees and
I don’t think it is. I think there is a danger that a lot of trustees – partly as a result of historic advice – focus on matching and growth pools as opposed to a spectrum of assets.
Dryer: Again I think you’ve got to have a bottom up approach to it. If you look within investment grade, there is certain value within some of the bank capital structures. Banking is a sector that is repairing, as is insurance. Any sector repairing its credit quality is going to deliver good returns both through the recovery phase in post credit crisis but also as you look through the next crisis.
There’s value in some of the less cyclical industrials too as well as some of the peripheral names. Where you have seen value squeezed down is in some of the more cyclical industrial names, and within lower rated high yield names. So when you move into high yield, the BB grade names will be potential M&A targets who are offering pretty attractive spreads to default rates.
Abrahamsen: In terms of corporates, their balance sheets are in better shape than governments. I’m still worried about the financials’ balance sheets because there are assets trading on their books that are not marked to market, they’re marked to something else and because of their potential exposure to sovereign debt elsewhere in peripheral Europe.
High yield, they’ve had a strong run and if you adjust for duration they’re yielding below loans for example, and loans are higher up in the capital structure. So from a risk/reward basis, I’d feel more comfortable in loans than I would do in high yield given where we are in the capital structure.
Maybury: The insurance world under Solvency II might have some interesting dynamics on those downgrades in terms of what’s treated
as the risk free rate for their liability valuing purposes. But also I think there’s an issue about the switch from a UK benchmark for example, to a global benchmark. There are not only concerns about the periphery in Europe but also the US and Japan. Does that influence some of these global mandates?Particularly in credit the US is a very substantial part of the overall global index.
Pirou: A lot of the global issues are linked to the governments
and not necessarily the corporates. Clearly there’s a link between the two, you could argue that corporates are going to price on the government curve but a lot of corporates have a lot of cash on their balance sheets and are in a relatively good position. In terms of duration, you might have an issue if you go from UK to global because you’re going to get lots of US duration. It’s possible to hedge. You’ve got an instrument to hedge the currency risk, you can also hedge the duration risk, you can potentially have a global benchmark that’s hedged back to sterling and then also to UK rates.
Abrahamsen: What you’re really saying is: ‘where can I go to make sure that I make good against those particular liabilities?’ Your problem is not solved by diversifying into a global opportunity set, all you’re saying is that you’re creating a wider playing field to select those issues that you want. Whether they’re in the US or not, if you can source them entirely in your own country – happy days.
Syms: It would appear that we all agree that there remains a number of opportunities for pension funds in fixed income. Active management is increasingly important for exploiting market inefficiencies and valuation extremes given that yields have been at historical near all-time lows. As the global economy recovers and inflation uncertainty persists, global inflation bonds remain a very attractive asset class to our investors.
Maybury: Can trustees select a manager that’s got a pretty broad set of skills, are there structures developing like fund-of-fund type solutions or are trustees really restricted to finding the house that can cover all of those things, not necessarily best in class in all of them, but to give them that flexibility?
Pirou: I haven’t seen many fund- of-fund products in the fixed income space. It’s an area I haven’t seen much demand for either. Certainly, our preference wouldn’t be to only go to one manager and give them everything because as you said it’s unlikely that one house is going to be good at everything.
Maybury: Does this mean that this is predominantly the domain of the larger funds, or are there pooled solutions that are available for the medium-size and smaller funds that enable them to do some of this without some of the governance overheads you may have associated with the individual areas of the fixed income market?
Nair: We have seen a lot of interest from funds, especially medium to smaller funds, in products where the manager has the discretion to allocate between asset classes. A good example is a diversified credit product where the manager allocates between HY, EMD and Loans. The challenge for consultants is to find managers that have the breadth and depth of expertise in multiple asset classes. Going back to governance budgets, there’s a lot of talk about how small clients cannot afford a big governance budget, but then you have to compare that to the opportunity cost, like what schemes are missing out on since the trustees cannot look at all the opportunities.
Maybury: This was a very fruitful discussion I think, which emphasises a number of points to me. The first is that we are in a circumstance where for trustees or as any investor there’s probably more uncertainty than there’s been for a while.
We then got to a position in early 2009 where if you could ride out some of the volatility there were very clear opportunities. It’s fair to say today those opportunities have been eroded by the performance we’ve had over the last two years.
We are in a major state of change from a global economy perspective, from the relative capability of providers of finance to all sorts of corporate and organisations, and therefore there’s a lot of very careful thought that needs to be given.
Trustees need to take as much advice as they can, and maybe need some framework or some mechanism for the relative value of all these opportunities.