A tightening in the supply of index-linked US corporate bonds may lead to UK pension schemes facing increased difficulty when derisking their portfolios, industry experts have said.
A tightening in the supply of index-linked US corporate bonds may lead to UK pension schemes facing increased difficulty when derisking their portfolios, industry experts have said.
The lack of available index-linked assets risks leaving schemes exposed to unexpected inflation rises in the UK, leading them to look elsewhere for index linkage. However, experts warn these overseas assets may not provide sufficient protection.
JPMorgan Asset Management research last month predicted demand for long-dated US corporate credit could outstrip supply by $1tn (£653bn) by 2019.
Rupert Brindley, managing director of global pensions solutions and advisory at the asset manager, said there were not enough index-linked corporate bonds in the UK, despite being the asset “most UK DB schemes would want to buy”.
“When they come to market they tend to get locked up and never moved again,” he said, adding the issuance of US corporate bonds so far in 2015 was $580bn (£379bn), versus around £13bn in the UK.
This, Brindley said, means the US supply and demand problem could spill over to the UK due to the appetite for US corporate bonds from UK schemes.
“The supply/demand imbalance in respect of US institutions will only be exacerbated by UK and EU institutional investors going to the US to buy these products,” he said.
Currency risk
Some UK schemes have been getting around the lack of supply by buying US corporate bonds and hedging the currency risk.
Chris Redmond, global head of fixed income manager research at consultancy Towers Watson, said: “We tend not to like that because you end up taking on a lot of risks or complexity in implementation you didn’t mean to. You’re introducing complexity into what should be a simple part of your portfolio.”
It may lead to changes being made to the benefits being received by many scheme members, such that they are asked to bear the inflation risk
Mark Gull, PIC
Mark Gull, head of fixed income at Pension Insurance Corporation, warned that schemes buying US corporate bonds “are buying US inflation not UK, so although there will be some coverage, it won’t exactly match”.
Gull said the lack of supply for index-linked investments “could have major implications for the solvency of both individual schemes and their sponsors, and by extension for the Pension Protection Fund”.
He said: “Ultimately, it may lead to changes being made to the benefits being received by many scheme members, such that they are asked to bear the inflation risk.”
However, he added the threat is exacerbated by the lack of alternative investments, which could offer inflation protection.
“It’s difficult for them,” he said. “Most schemes are not well placed to invest in direct infrastructure debt, a good source of index-linked cash flows. In fact, there is likely to be a serious problem in this regard over the next decade or so.”
He cited a report the PIC produced with Fathom Consulting last year, showing schemes and sponsors could face a shortage of more than £500bn of index-linked government bonds over the next decade.
“The proportion of the gilt market that is index-linked would need to rise from 25 per cent to 75 per cent in order to meet the needs of DB schemes over the next 10 years,” Gull said.
