Do schemes fully understand their fixed income risks?

William Nicoll: They are very good at investment-grade risk. However, the investment-grade market and the high-yield market are very separate beasts, in terms of what you are getting paid for.

If you are looking in the investment-grade world, you have something where you are still being adequately rewarded for the credit risk. It is not as exciting as it was; the credit spread, although tighter than it was, is not crazy. You have to be selective and follow all the standard rules when investing in credit markets.

However, it is a mature and reasonable market that is giving some extra return for the risk. The high-yield market has always been much more cyclical and it is very difficult to make long-term strategic allocations.

If you look at long-term views on the high-yield market, you very quickly come to the conclusion that you would not buy a CCC-rated bond or a B public bond at the moment. You are not getting enough return to cope with the default risk.

Pension funds get the idea of the benefits of investing for the long term in investment-grade credit. I am not always sure they should take that view into the high-yield market.

Tim Giles: It is all about fair reward for the risk. I am not saying that credit spreads are crazy at this time and they are about to fall very rapidly. They just keep tightening and tightening, and at some point in time you think, ‘Yes.’

Nicoll: And there is clearly a level of spread that you would not want to buy. If you look at some infrastructure bonds then the demand for those is so great that the returns on the liquid assets are quite low. I really would not bother to do that when I have so many other things I can do.

David Felder: High-yield reached a low at the end of June. Retail selling and various other factors precipitated quite a significant sell-off in that market in the subsequent period. With pension funds, there is no reason to have an intrinsic core passive exposure to this area.

You can have as your core, investment-grade credit.; that serves the duration purpose. It also gives you a fairly stable flow-through of a reasonable credit spread. The other sorts of strategies around it are essentially opportunistic.

Carl Hitchman: The subject of credit risk is something [that] needs to have a lot more prominence. One of the challenges faced in talking about these alternative assets is people’s concerns in moving from investment-grade credit to sub-investment grade.

Understandably there is a nervousness over credit risk when considering bond mandates. However, it does strike me as a little bit strange as to how much time is spent in agreeing control parameters for bond mandates, yet when an equity mandate is set up the issue of credit risk is not something that is generally considered in agreeing the mandate terms of reference. Yet equity holders, generally speaking, carry the highest level of risk in the event of insolvency.

In considering sub-investment-grade credit, it is important not to simply focus on the credit rating but rather the size and risk of potential loss. For example: which is more risky – a portfolio of UK equities with an average credit rating of A or a portfolio of sub-investment-grade credits secured against assets of the company resulting in an expected high recovery rate in the event of default?

John St Hill: It is all very well having a nominally investment-grade portfolio, however, that does not substitute for just understanding what cash flows you are going to get from the investments you own.

It also does not substitute for knowing how well those cash flows match your liabilities and how well they help you recover your deficit.

The problem is that it is easy to look at the credit rating of your portfolio and say, ‘Okay, I have a portfolio which has an average rating of A or AA. Therefore, investors feel comfortable with that.’ Actually, a sub-investment-grade portfolio [that] has better covenants on the individual bonds may be a better portfolio for investors.

Pensions Expert: How confident do you think pension schemes can be in ratings, given the experience of the financial crisis?

Nicoll: Again, any single-factor model is never going to work perfectly. If you talk about the public high-yield market, in general you are quite low down the capital structure. In general, you are quite subordinate, you have no covenants.

If you talk about the leveraged loan market you are at the top of the capital structure and you usually have good covenants. If those two markets are trading at the same level it appears to be pretty simple to decide where to put your money. That is especially so, given there is some liquidity in the loan market as well. The loan market is an attractive market.

However, if you looked at the leveraged loan market, then the rating – depending on which rating agency you look at – is the rating to the first pound of loss.

Would you rather have an asset that gives you Libor plus 4 per cent and in the worst case will give you a 95 per cent recovery? Or would you rather have something that gives you Libor plus 3 per cent that has a higher credit rating, but actually if it goes wrong you are going to be wiped out completely?

St Hill: The Pension Protection Fund has an interesting perspective, because we see the schemes where the plan sponsor has become insolvent. It is interesting to see the range and variety of swap agreements that have been agreed between pension funds and between banks.

One of the exercises we do internally when we execute new swaps is ensure the terms and conditions in the swap agreement are appropriate for protecting our members’ best interests.

However, we find that when schemes come on board, the terms that have been agreed for those swaps are not always to the same quality as the terms that we have for our swaps.