Fixed income is no longer simply a matching or diversifying asset for pension schemes. Pan Trustees' Andrew Cheeseman, Towers Watson's Ed Britton, M&G's Richard Ryan, Aviva Investors' Dan James, GSAM's Jeremy Cave and PiRho's Nicola Ralston look at how its role has changed.
Ed Britton: If you go back a long time, fixed income was there, it was diversifying, it was meeting some liabilities. We have gone through a phase of many of our clients using synthetic ways of matching their liabilities, using swaps a lot or using gilts and repaying the gilts to free up cash to then do more interesting things.
So you have got all that conventional stuff going on with fixed income, but the repaying gilts and the derivative approach means you have lots of cash free and you do not need to use your bonds to do that liability matching.
So bonds are now in there at least as much for their return potential and their diversification potential, and that is changing the way people think about bonds – you can globalise, you go down the credit curve.
Richard Ryan: I see it from the other side of the fence, which is that pension scheme allocations into fixed income have moved, especially in the past 18 months or so, from being a diversifier or a cash flow generator into an alternative for pension schemes as they derisk away from equities and into fixed [income].
The other thing we have seen has been the breaking down of artificial barriers. Until now schemes have held government bonds and credit, and credit has been mostly investment grade, albeit sometimes touching on other areas. However, there is now more awareness that credit is very simply just a lending exercise and schemes are looking at the risks they run and whether these can be put together in a better way – whatever format, jurisdiction or legal framework it comes under.
Andrew Cheeseman: There are two sizes of scheme to consider when looking at such issues: there are the larger schemes, which I think the first two people have referred to; and then there are the remainder of the schemes, which probably account for 80 per cent of pension schemes.
The problem we have is that it is fine to adopt wider solutions for the larger schemes but the small to medium-sized schemes do not have entry into the markets – and so yes, it is a diversifier if the product is available.
Although we can debate the size of a small to medium-sized plan, true diversification of the fixed interest portfolio at reasonable cost would only appear available to schemes in excess of £100m. Therefore the majority of schemes are still faced with the problem of how to diversify their fixed interest portfolio.
Dan James: We see many people coming with different requirements, so it depends on where they are on the spectrum in terms of derisking and their other requirements – and so it can be used for a number of different things, be it to swap liabilities or just to simply meet that core cash-type portfolio that people want at the maturity point at the front to provide the cash flows.
But you can also do some interesting things – if you look holistically at products it is more about the overall risk of your portfolio and potentially using fixed income to be a diversifier of that pool of risk, or hedging a certain spectrum that you are not necessarily covered for, or you have an exposure to that you do not want. You can actually use fixed income instruments to engineer hedging strategies, and we are seeing other people talking about that as well.
Nicola Ralston: I cannot help thinking that much of this conversation would be largely incomprehensible to many clients – does that mean the industry is becoming too specialist, too complex?
I completely agree with Andrew’s point about the challenge for smaller schemes. I am always very interested in vehicles as well as concepts, since it matters whether pension funds have a practical means to do these things. Another point is that if you have your matching portfolio in some kind of leveraged liability-driven investment-type product, this frees up cash to do other interesting things – then the question is what are the other interesting things you can do in bond markets?
Once you have done your matching piece, you do not have to invest in fixed income at all – arguably, you might want to for risk and return reasons, but I would say look at a variety of risk sources, albeit that some of them might happen to be called fixed income.
Jeremy Cave: Your description of managing the different risks in a complete portfolio is an interesting point because I am not sure that we can feel so confident about the negative correlation of long-duration assets in a fixed income portfolio with equity volatility in the future, simply because yields are so low.
Whatever your view, whether rates are going to go up or down, if you saw equity market weakness, it is not so clear that fixed income will provide uncorrelated returns.
Second, that leads us back to the point you were making about the strategy of shifting assets out of equities in order to reduce the potential volatility of your solvency ratio.
Today, if one followed the traditional strategy of switching into very low-yielding assets, such as gilts, you are guaranteed a zero or negative real return, and so allocating to multi-asset credit products seems to us to be a very sensible approach as it will reduce volatility but should deliver superior returns.
So, we are suggesting that such credit portfolios are a rational alternative to equities in the return-seeking portion of the portfolio.
However, given the large duration sensitivity of pension fund liabilities, comparing the risk of such credit portfolios to traditional long-dated, high-quality fixed income assets is inappropriate.
