Riding the waves of change
Written by European Pensions team
Chair: Nick Secrett, Director, PwC
Bernard Abrahamsen, Head of Institutional Sales and Distribution, M&G Investments
David Bennett, Managing Director, Head of Investment Consulting, Redington
Nick Gartside, International Chief Investment Officer, J.P. Morgan Asset Management’s Global Fixed Income, Currency & Commodities group (GFICC)
Steven Hay, Head of Rates and Currencies, Baillie Gifford
Alex Koriath, Director, Head of Fund Manager Research, Investment Advisory, KPMG
Chair: We’re in a new world. What is the general sentiment around the fixed income space, particularly when every paper you pick up says that it is an absolute certainty that rates are going up?
Bennett: I think the first thing to do is distinguish between credit spreads and fixed income rates because there are two drivers of bond yields. Over the last year or two there has been some excellent opportunities with regards to credit spreads that were really very fairly priced and quite cheap in some asset classes. There has been very strong activity from our clients to take advantage of that, particularly in the ABS markets where there were some complexity issues that kept a number of people out of the market, plus some supply and demand imbalances and also in some of the more esoteric markets like high yield and leveraged loans. The outcome of that is that credit spreads are heading back towards the tight end of the range and we are starting to see some questions being asked about whether there is still value there, particularly concerning high yield. On some measures there is no value left there whatsoever. This is the first area that has hit the buffers. We are seeing a trend of trying to find other sources of yield mainly through less liquid assets still focusing on credit spreads rather than bond yields. Regarding the bond yield components, I would say that we have observed a hiatus from people wanting to increase their exposure to interest rates. The signs seem to be at the moment that there are second thoughts coming through on that side of things and we could stay where we are now for quite a long time, in which case perhaps people will start doing some more interest rate hedging even with rates at record low levels. When people do that they will look at the roll down and carry effects, so in other words if you are sitting in a massive short position as a pension fund expecting rates to go up, rates have to go up quite a lot just to hit the forward rates.
Hay: I agree with a lot of this. It has been a fantastic environment for fixed income managers in the last few years. It has been a one way street with fantastic pockets of value after the crisis and everybody realised that there was an awful lot of value there. There were fantastic returns out of high yield, investment grade and now certainly you are looking at levels that are nothing like as good value as what they were before. I think it is quite difficult now for fixed income fund managers because they have been in an environment where things have looked such good value and now things have moved so far that it becomes more of a stretch to argue the valuation case. I think this is largely a result of quantitative easing (QE) which has pumped up the markets. Leveraged loan markets are still offering good value but it is now harder to find sections that are still undervalued.
Bennett: Regarding the value in credit spreads, particularly investment grade, there is perfectly enough spread there to compensate for default risk. The issue that we are facing with our clients is that if you think back to three or four years ago, investment grade spreads were well over 200, 250, even 300 - not too far away from the equity risk premium. So you could ask people whether they wanted to be in equities or credit as a almost direct comparison. Now you are coming down with credit spreads nearer to 100 for the investment grade and the problem we have is that this no longer contributes so much towards our clients’ returns that they need to hit their objectives. Before, it was a really good building block in the portfolio and it could help towards achieving gilts plus 2, gilts plus 2.5-type pension fund return targets but now it is much more difficult for it to make that contribution.
Koriath: It is very difficult to look at credit spreads or rates in isolation. You have to look at elements like QE and the wider economic situation we are in. We believe that what is taking place at the moment is an assisted recovery. Once the stimulus is taken away the question will be what risk asset do you want to be in then? Our view is that people should be higher up the capital structure and not in the residual equity piece. You want to be in something that gives you a bit more certainty and a bit more contractual protection for your payouts. Overall when QE is taken away all risk assets will be hit and I think equity will be hit as much as high yield. The key is looking for value within fixed income but this must not be looked at in isolation.
Abrahamsen: When people talk about a bubble in fixed income, I think that is fundamentally not the case for a number of different reasons. From first principles you get a bubble when there is no underlying cash flow, like in the dot-com era. But bonds are still throwing off cash and they are still fulfilling a purpose so it is unlikely that that will constitute a bubble. The other aspect is the central bank activity. We may well be in for a period where we have to be satisfied that current rates are not really that abnormal given the conditions that are prevailing. Given there is a need to close funding gaps there is this dash and grab for yield. This is where care needs to be taken because there I think some are losing sight between understanding the risk and being sufficiently compensated for that risk. Spreads have contracted so where does one look for this so-called value? I think that liquidity is mis-priced and that is essentially where owners of long-term capital, be they pension schemes or insurance companies, can play a role. That coincides very nicely with banks shrinking their balance sheets.
Gartside: QE, we would say, is a policy that is failing and is doomed to fail because what it does very successfully is it inflates financial market asset prices but the impact on the real economy is minimal and we would say it always will be because ultimately the other side of the equation is that QE creates a lot of money, it lowers the cost of money but it does nothing to generate demand for credit when the propensity is to de-lever not re-lever.
Hay: I disagree with that. In terms of what QE can do, you would expect that the financial markets going up would filter through to wealth effects that make people feel wealthier. It helps their balance sheets, therefore the need to de-lever is less so the appetite for credit has the potential to grow more as a result of QE. I agree with the fact that it hasn’t had much impact yet, but there is definitely a route in which it can work.
Gartside: There is a huge cost to QE and that is the mis-allocation of capital. I think that effectively perhaps QE was very good initially in insulating the financial system and preventing collapse but the longer you go on with QE, the law of diminishing returns kicks in and the probability of an adverse impact increases. I would say we are arguably there now where it is potentially very damaging and it means that recovery perversely takes longer.
Chair: One thing that strikes me is not just because of where spreads are, not just because of where rates are but fixed income is in a completely different place to where it was pre-2008 when so much of what was happening was being driven by leverage buyers, whether it was CDOs or hedge funds. I got the impression from the outside that a lot of the real money guys were standing back and saying that there was just no value. Now with that having gone, has that for your individual companies changed in terms of the products that you are offering and the feedback you are receiving from clients?
Bennett: There are pockets of opportunity now surrounding commercial real estate debt where the banks are much less active and there are some very good risk-adjusted returns there. The broader issue of bank deleveraging is definitely an ongoing theme.
Chair: It is interesting that we talk about these opportunities but if you look at the deals that have been done, most of it has actually been where there are hedge funds or private equity funds on the other side of the deleveraging chains as opposed to the insurers or the pension funds doing it. I thought there was a huge opportunity for pension funds but it doesn’t seem to have got down to that market yet. It seems to be being picked off by the private equity investors.
Bennett: It is the usual pension fund pace however. There needs to be quite a bit of education and training around this and governance bandwidth constraints just cannot move that quickly.
Abrahamsen: It is hugely exciting right now. Owners of long-term capital are in the driving seat. Banks are deleveraging so where do people go to source capital to re-finance? Before, when we were talking about investment grade, we were effectively the price takers, now pension funds are in a position where they can be price setters. Banks are not able to refinance to the same extent that they did but they can’t provide term finance to companies, social housing or even infrastructure. So pension funds have the ability to lend for longer than the banks for which you can charge a premium. Owners of long-term capital, providing they are being selective, can set price rather than being price takers because capital is scarce in a deleveraging world.
Hay: Do you think that pension funds need to relax their criteria in terms of liquidity and their willingness to hold funds that maybe are that bit less liquid?
Abrahamsen: In the last financial crisis you had no liquidity. In other words you paid for something that you couldn’t get. Yes, criteria should be relaxed because liabilities are going out for 30, 40, 50 years so pension funds must change this. Also, instead of pouring money into the corporate bond market, pension funds should look to diversify within the much broader fixed income market.
Gartside: It is a mindset change for pension funds because ultimately pension funds should not care about liquidity - they should care about cashflow for the most part. If good credit work has been done and you are comfortable with the credit, actually then what the value is is irrelevant as long as you are getting the cashflow.
Abrahamsen: Sometimes people are afraid to lock away their money in the fear that they might miss out on an opportunity that they don’t know exists around the corner.
Bennett: When we are looking at illiquid assets there are a few constraints. One would be whether one has any imminent buyout plans and will the asset be suitable to be going into whatever buyout solution you have. The second constraint relates to liquidity - the last thing you want to do is to be a distressed seller of an illiquid asset. The third thing that comes in when we are looking at illiquid assets is first of all the idea that you have to come up with some construct as to what is the price of this asset relative to a liquid asset. You need to be able to say what am I getting paid for this additional illiquidity. The very difficult aspect is coming up with a number as to what this should be. When taking illiquidity risk you have to ask yourself how much value will I add by moving my asset allocation around and to what extent will this constrain things from a strategic perspective. Accomodation of both illiquid and liquid assets is the most pragmatic solution within a portfolio because there is a limit from a prudence perspective as to how much you would allocate to illiquid assets within a scheme. From the numbers we have seen around 10 to 15 per cent of portfolios are dedicated to illiquid assets.
Abrahamsen: Illiquid also means that you do not lose the cash flows.
Koriath: I think you are absolutely right. Pension funds should look at illiquid assets more than they are doing so now, but to quantify risk and return for illiquid assets in a convincing meaningful way is not that easy.
Bennett: There is also the issue of when liabilities shoot up because gilts have gone down, and your asset doesn’t move because it is illiquid. When you then come to the next triennial valuation, can you convince the scheme actuary to give you any credit for that relatively high spread on that asset because it hasn’t moved? Therefore that could result in some benefits to the liabilities or will there be a situation where the trustees go to the sponsor and say look even though there is an asset that matches liability cash flows the gap has just moved 10 per cent and they need more money.
Chair: There is an additional complication surrounding this however. The one thing that trustees have been told time and time again is ‘don’t invest into anything that you do not understand’. One of the problems as a general rule with the illiquid bucket is that it is not clear to trustees as to where the value from that asset is coming from. It is hard to communicate that to a lay group of trustees who at the end of the day are the ones who have to take responsibility for this. As you have seen opportunities emerge, how easy has it been to engage the end buyers to take advantage of these assets, particularly the smaller pension schemes?
Hay: We have found demand from the middle tier of pension funds for some kind of multi-asset investment has been strong. We have a fund called Diversified Growth and we do invest in some illiquid parts of the market and I think people understand that there is a trade off between illiquidity and return and people are willing to accept lower liquidity because they are looking for higher returns. As long as you have a clear way of explaining what you are doing then I think people will understand it. But you are right, it is a challenge. As a side point, we have talked about pension fund horizons being long enough to take on this liquidity risk, but are pension fund trustees in position long enough to share the long-term horizons that their pension fund should have? Sometimes if pension fund trustees’ terms are shorter will that bring in shorter-term behaviour which stops them from taking watch on a longer term?
Gartside: I would echo a lot of that. The growth we have seen is in what we call unconstrained bond products that don’t have a benchmark and try to do a lot of things that have been mentioned in this discussion. We have seen a lot of success in these products but what we have found is that there is always a need for an external validation, so that is the consultant who can provide that level of assurance to a board of trustees.
Bennett: I am a big fan of unconstrained fixed income mandates. The real issue is to know where to draw the line as to what can go into this type of mandate. I think if you are just sticking to investment grade UK credit you do not get the benefits of going into other currencies or other ABS. As broad as possible is the best way of achieving the best outcome but then it raises the bar in terms of the explanation to the trustees. If someone says that it would be a good idea to put 5 per cent CLO equity in a specific fund, you then have to spend an hour explaining what a CLO equity is, which may or may not be well received by that particular trustee board.
Koriath: We are advising clients to consider sectors that offer risk- and liquidity-adjusted returns like real estate debt. It is easier to communicate such fixed income strategies to clients than a hedge fund strategy because fundamentally it is lending. It is either secured or unsecured lending but you are able to open the bonnet and have a good look at who you are lending to.
Abrahamsen: If you are looking at senior mortgages or sale and lease back property, they have different maturity profiles and different levels of liquidity for example. Trustees have to be aware of this. We are not talking about the same type of liquidity that exists within the public debt arena.
Gartside: Where we have seen the growth of unconstrained strategies is that small pension fund that has a lot of gilts or loads of sterling credit and now says that this is a nonsense. It’s a nonsense because within the benchmark there is a huge concentration of risks. There is a lot more government risk than they thought, there is a lot more duration risk and in the credit part there is a lot more financial risk and compensating yield is at a record low. So what you do is you stay in the public markets but throw that benchmark away
and you say let’s take the global approach and opportunistically pick where we want to allocate. You might have some emerging market debt or some high yield in the portfolio and it just means that you are getting rid of that benchmark risk. To do this, you have to be ultra transparent in how you obtain returns and how the portfolio is built up. You then pass on a lot of underlying comfort to the client.
Koriath: How do you measure the success of such a mandate? Is there a lot of beta risk involved with this?
Gartside: Ultimately, for us the risk is beta risk. So it is allocating to the right market so that could be duration FX sector selection and we measure it over cash or it could be measured over a liability benchmark.
Chair: We have seen quite a lot of growth in buy and maintain portfolios so the idea being that you are cogniscient of a benchmark but not tied to one. Are you seeing a corresponding growth in this area?
Bennett: We do have buy and maintain mandates. We construct a bespoke benchmark which is the portfolio on day one and then track it against that to see whether the appropriate job is being done. It is fair to say that with spreads tightening we are seeing signs of people moving out of these portfolios as they are chasing a bit of extra spread from some of the other opportunities that we have been talking about. On the more absolute return mandates, there isn’t really a benchmark because you are giving the manager the opportunity to do quite a lot of different things. A cash-based benchmark seems fair. Again risk management is important here and what we are looking for is that people are not making heroic and quite aggressive bets that are bringing in risks that you really do not want.
Koriath: The problem that I have with a cash benchmark is that there can be the incentive to constantly take risk in order to beat a cash benchmark.
Abrahamsen: I have no problem with unconstrained public credit mandates, providing you are trying to satisfy that it is sustainable and no undue risk is being taken. Also that there is a greater probability of succeeding in hitting the benchmark as opposed to having free rein to invest in something that you hope will beat cash. By having a fixed benchmark purely in corporate bonds it can force you to take unnecessary risk. If you have an unconstrained mandate you can rotate out of those assets that are not compensating you sufficiently for the risk that you are being asked to take.
Bennett: What do you think about allowing credit portfolios to have quite a bit of duration risk in the mandate?
Hay: We are very clear to separate the duration risk from the credit stock-picking risk, so all of our corporate bond funds are just about picking the best corporate bonds and we don’t take any duration risk within those because I think there are dangers associated with that.
Chair: Moving on, obviously the regulatory regime in the finance world is forever changing on us, how is this impacting on portfolio construction and targets?
Gartside: One thing that we have seen is actually a move towards unconstrained strategies where a lot of schemes have wanted to use fixed income not only as a hedge but something that can also deliver a return. So they want some kind of positive return from their fixed income and they can’t make that big step into equities. That is suitable for opportunistic strategies. The other change that we feel that should be made is that emphasis on looking at cashflows. The regulator may or may not have some sympathy with that view. We feel that the regulator should because ultimately that is what matters to pension schemes.
Abrahamsen: Something that I fear most is when you have regulation not coming from our own pensions regulator but more broadly, be that on a solvency basis that is not properly thought through. That potentially has a huge impact, asking pension funds to de-risk at a time when they should be taking risk for example. This type of legislation is unhelpful. Thankfully, Solvency II is coming under more and more scrutiny and hopefully this is also the case for pension schemes, although that is something that the pension fund industry as a whole should lobby against. Furthermore, there is also the issue of the Financial Transaction Tax (FTT) and this will have an impact on schemes that have large liability driven investments and hedging strategies. The cost of that will be brought into question and also the issue of funding the cost of those swaps. In the Netherlands the regulator is being a little bit more prescriptive in terms of the type of assets that pension funds may invest in depending on their solvency. That needs to be thought through very carefully and hopefully we do not go down that route.
Koriath: I agree that the Financial Transaction Tax and Solvency II could be quite damaging but I am not convinced that it will hit the UK in its current form, we will have to wait and see. On a more practical note, I think it would be helpful if the point around illiquidity and that pension funds can take more illiquid assets would be supported from the regulatory side. Pension funds do not need to be able to liquidate their whole portfolio in a day and should be able to take advantage of more illiquid opportunities.
Hay: I too hope that the FTT does not come in its current form. As an active fund manager it is not a great thing despite our investment style being long term so we will most likely be less affected than others. My point on any regulation is that I am very wary of it because it changes incentives and distorts to some extent behaviour. Pension funds need even more flexibility and freedom. Of course I understand why there are some regulations in place but you have to understand what incentives there are in relation to this. Currently we are going through a period of financial repression in the UK, trying to reduce the level of debt in real terms by having real interest rates negative for an extended period. This is what you are facing as a pension fund trustee and therefore there is an incentive for money to be placed outside of the UK, but of course that attracts charges in terms of the risk profile. From a practical point of view, all the changes to central clearing of derivatives and collateral management are also taking place and that is causing a bit of a practical headache in terms of knowing where we are going to end up with this.
Abrahamsen: It is quite ironic in a way that if you speak to government, pension funds are going to be funding all the re-financing, helping to build roads because they are the ones with a lot of the money.
But they forget that pension funds should not be overburdened with rather unnecessary politically motivated legislation as pension funds are the owners of long-term capital and are the financiers.
Bennett: Picking up the point of central clearing and the cost of collateral is that that actually makes potentially physical assets more attractive. A physical asset can be bought and it matches the liabilities against the derivative.
Koriath: In terms of sentiment, there should be more recognition that this does not have to be a one way de-risking street. Once you tactically take risk off it should be ok to take that risk and move it back into the market. You can add it back when there is an opportunity. At the moment, there is a fear that once you take this risk-off strategy, you cannot re-deploy it back into the market. This prevents tactical de-risking in recognition of market expensive valuations.
Chair: What do we think about the idea of pure passive fixed income investment versus active? Obviously we have seen a lot of work particularly in the equities space about smart beta and different strategies and weaknesses of passive approaches. Has there been much change around this?
Bennett: I wouldn’t say I have seen much change but I am certainly very open to the idea of active management in fixed income. There are some very impressive track records out there and in particular to the avoidance of defaults.
Gartside: There is a problem though with the fixed income benchmark in that they just reward a debtor. They reward someone or an entity that has behaved badly. Going back to some of the opening points, in a world where there is too much debt that is an extremely big issue because you allocate more capital and lend more money to those who are more indebted and they are less able and potentially less willing to repay you. If you think when fixed income indices were created in the mid-eighties, it was different because levels of debt were that much lower. In the world we live in now, they actually concentrate risk as opposed to diversify risk.
Abrahamsen: I disagree quite strongly here. A big company is able to sustain a lot of debt. Companies like EDF, RWE and GlaxoSmithKline are not overstretched in terms of levels of indebtedness. They can afford to have that and their ratings reflect that. I don’t think it is appropriate at all to just naturally assume what the market is offering and saying that this is the risk that you should be taking. You should be highly selective.
Gartside: But most managers relative to a benchmark are not. Investors are very worried about their tracking error and they are very obsessed about an alpha target so the reality is that they will not take a big bet on this in absolute terms relative to that benchmark.
Bennett: One of the issues that we have certainly seen over the years is closet index hugging with an active fee. Is that still going on?
Hay: A lot of investors are still doing this but that is not what we do. We run fairly concentrated credit portfolios of 50 stocks but there is a capacity issue that if you are over a certain size that is very hard to do. That is why people start hugging the index, because to get the money that they have under management into the market they have to buy these big issues. If you move to the sovereign world the share of a country’s debt in the index doesn’t necessarily reflect bad credit fundamentals because maybe the country is growing very fast and therefore can support that level of debt. There is that risk that if a country starts to borrow too much it could start to have a concentration in the index. That is what we see in a typical developed global bond index which has a big weighting to Japan, a big weighting to Europe and a big weighting to the US. Our emerging market bond fund follows an emerging market index which is capped at 10 per cent per country so you do get a good diversification between each country. I would advocate as much diversification as possible within the sovereign world and that is not what the current indices tend to do.
Abrahamsen: In the current environment you do not want to be trading all the time as there are a lot of transactional costs and frictional costs involved in that, when the credit fundamentals are effectively stable. You do need to have the flexibility that when something does move out of line to be able to exploit that. I don’t think that all of your portfolio can be in those outliers however.
Koriath: It comes back to the point of benchmarking. Most of the corporate investment grade pooled funds are run against the wrong benchmarks, which include a large amounts of supranationals and other quasi-government bonds. With such a mandate dialling credit beta up or down is what most of the managers are doing out there. If you take more risk than the market, it is usually not through stock selection, it is simply taking more beta risk.
Hay: There may be a place where you want to take beta risk in your portfolio as long as you are clear what your manager is doing. With regards to the active versus passive debate, there is always a temptation to do something. Acting feels better than doing nothing. It is a behavioural trait that is hard to get away from. There is always a pressure of quarterly performance numbers.
Chair: What do people think will be the next major moves in the industry over the course of the next year or so, whether it is investment style, market movements or investor appetite?
Gartside: I think that the big trend will be a level of astonishment at the returns that fixed income delivers. Investors will look back and be astonished that these instruments that now yield a little above zero have delivered such a positive return over the next 12 months or so.
Abrahamsen: I think we are living in economically challenging times. I would concur with what Nick has said and we may well be surprised. There will be plenty of opportunities for owners of long-term capital to provide that capital in private lending, disintermediation of banks will increase and pension funds and owners of long-term capital will be price setters. This will be very exciting for those who have the governance structures in place to take advantage of that.
Koriath: If you have the governance structures in place and can take advantage of what will be a bumpy road to recovery, you might not be in a bad situation and might be able to capture some interesting opportunities. Apart from that, we are in a situation where we have come to realise that returns will be lower.
Hay: The forces of demographics and people wanting to reduce risk are very strong at the moment. The issue for people who are making investment decisions are that things are going to feel more expensive. As a sterling-based investor I think you will try and get more money out of the UK into countries that don’t need to do as much currency debasement.
Bennett: The additional element that we would expect to continue this year would be people seeking the illiquidity premium and being a bit more adventurous in some of the asset classes that we have been talking about in terms of direct lending to smaller companies and CRE lending.