Altmann: Exceptional measures needed as monetary policy tightens

Have unprecedented central bank interventions – such as the Bank of England buying more than a third of UK gilts – distorted sovereign bond yields, rendering traditional measures of investment risk less reliable? How should trustees position themselves for sharp rate rises and the unwinding of quantitative easing?  

Can trustees still rely on historic correlations to assess their portfolio risk if the base asset is artificially distorted? 

In theory, a fully hedged, fully funded scheme should see liabilities fall to match bond losses. However, in practice it is impossible to fully match all liabilities, and schemes with large deficits still need to outperform bonds.

Trustees are therefore considering improving scheme funding over time by being underhedged, to reduce deficits as yields rise.

Decisions on the level and timing of underhedging partly depend on trustees’ macro views and the strength of the employer covenant, but this is a focus of discussion at the moment.

There are also concerns about assessing relative investment risk when artificially low bond yields could mean other assets, whose valuations were traditionally determined relative to gilt yields, have become less risky.  

Even though fixed income yield spreads have fallen, non-gilt bonds could be less risky than gilts because the UK government must continue issuing gilts to cover its ongoing deficits.

Corporates have raised huge sums in bond markets in recent years, thus reducing the need for significant new issues in future. Therefore, underweighting gilts might actually imply reducing portfolio risk.

Similarly, trustees are considering what this environment means for assessing the risks of other assets. Can trustees still rely on historic correlations to assess their portfolio risk if the base asset is artificially distorted?  

Many trustees are increasing overseas asset exposure, as well as private equity, infrastructure, forestry or real estate.

Using a more broadly diversified asset mix to try to benefit from different types of risk premia, including illiquidity, aims to control risk rather than relying on models based on gilt yield correlations.  

Many trustees feel the relative risk of such portfolios is lower than historic measures suggest and offers a better chance of fixing funding shortfalls.

Finally, the exceptionally low level of volatility in markets in recent times may offer opportunities. Global markets seem to be pricing in plenty of ongoing good news.  

Given the economic and geopolitical risks, some trustees are considering using derivatives on market volatility indices as a way adding value, as well as protecting their portfolios against unexpected shocks.  

These investments were very profitable for funds I worked with during the financial crisis, providing potential sources of return as well as downside risk protection.

Such non-conventional asset decisions are examples of the challenges facing trustees who need to outperform liabilities, but also protect against sharp deteriorations in asset values. These exceptional times may require exceptional measures. 

Ros Altmann is a pensions and economic policy commentator