Hunt for yield
Written by Alistair Wilson
Alistair Wilson explores how bonds can be used to capture shorter term opportunities and match cashflow requirements for pension funds
Historically, pension schemes have focused their bond portfolios to match their long tail of liabilities. Until 10 or so years ago, this basically meant holding a portfolio of long dated gilts. Then, as time moved on, corporates started coming into the equation as investors weighed up the additional spread available versus the risk. Not surprisingly issuers caught on to this and, whether UK government or companies, they started issuing larger and larger amounts of longer dated debt to meet the demand.
This suited both sides for a long time as, with interest rates falling, long duration has been your friend for the last 20 years and returns have been good, even if the impact of these rate changes has had a less than desirable effect on a scheme’s liabilities.
With the advent of liability driven solutions, approaches have become far more sophisticated over time, but the end result has been that the UK now has the longest dated, and therefore the most exposed to credit risk, indices in the world.
Taking a step back then, why are we holding bonds to start with? Whilst long term liability matching is an important part of the equation, it doesn’t take account of some of the most important attributes of the bond market. They are an asset class that gives you a relatively secure cash flow with a low level of volatility, particularly if the bonds held are relatively short dated. From a portfolio design point of view, this should be attractive to schemes that have shorter term cash flow requirements and want a degree of certainty.
As we have experienced, equities by comparison give high volatility which should, in theory at least, be rewarded over the long term. However, whilst offering relatively high yields at the moment, equities don’t provide much confidence of avoiding short term ups and downs and so are not the ideal asset to use to meet shorter term pensions in payment.
How can pension funds best use their bond portfolios to help meet nearer term cash flows? Some
of our thinking at TwentyFour has concentrated on portfolios designed to capture shorter term opportunities and match cashflow requirements for pension funds.
In March 2012, we launched the Focus Bond Fund offering a yield of up to 7 per cent. The fund was designed to generate more certainty of return for investors and minimise duration risk, by selecting corporate bonds from Europe that are due to redeem by 2016. The fund mainly invests in lower-rated investment grade names and the higher quality high yield companies.
In order to reduce default risk, the fund focuses its investments on a relatively low number of favoured issues (around 50-60 bonds) and will not take excessive credit risk in the lowest rated issues. At launch, the fund had an average rating of BBB and held 30 per cent in high yield.
The fund is designed to help with investors’ ‘hunt for yield’, taking advantage of the mispricing that had occurred in credit markets due to the chaos in Europe and that left the relative and absolute yields on offer from corporate credits compelling. With official interest rates stuck at near zero, and with the yields available on government bonds at very low levels, the yields on offer from European corporate bonds continue to be very attractive.
To provide the 7 per cent yield, the fund is taking a higher risk of default than by investing in government bonds, but it is believed investors will be adequately compensated for taking this risk. Since launch on 29 February 2012, the fund has performed well with low volatility whilst paying suitably high income to meet pensions in payment.
Alistair Wilson is head of institutional business at TwentyFour Asset Management