In the latest edition of Technical Comment, Natixis's Olivier de Larouziere argues that pension funds' asset allocations will have to adapt to a "lower-for-longer" environment on interest rates.
Effectively, scheme members need to get their money back in inflation-adjusted terms and then some, reflecting the return on capital in a growing economy.
In this respect, negative real bond yields must represent a considerable challenge for pension funds. Real yields on UK government bonds linked to the retail price index inflation maturing in 2068 currently stand at -0.40 per cent.
Key points
Enhanced diversification and balance sheet flexibility needed to avoid negative yields
Pension funds should seek opportunities in loans and private placements
Asset managers to assist pension funds in achieving higher returns
Leaving aside discussions on the relevance of RPI as a gauge for the cost of living, it may be fair to say that risk-free investments, such as lending to the government, no longer maintain purchasing power for UK pensioners even at very distant horizons.
Scars from the financial crisis are still evident in parts of the UK and global economy. Working out high levels of household, corporate and public debt may thus require low policy rates for some time.
The asset allocation of pension funds will have to adapt to a lower-for-longer rate environment with likely negative consequences on pension solvency ratios.
Methods for a low-rate world
Liability-driven investments are now commonplace across the pension fund industry. Inflation swaps, for example, enable one party to receive payments tied to price indices against fixed payments and may be highly relevant in the context of pension funds’ asset management. The use of cost-effective derivatives contributes to balance sheet flexibility to be used for return-enhancing investments.
The financial crisis brought about unconventional monetary policy by major central banks. The massive increase in money supply resulted in widespread asset price inflation in many economies. Liquidity injections have indeed lifted all boats.
Such an environment brings the argument for a high degree of geographical and asset diversification in pension fund portfolios.
The crisis also changed sovereign bond investing considerably. The pool of AAA-rated assets has shrunk while a greater proportion of government debt markets now carry significant credit risk. The dearth of risk-free bonds has caused yields to collapse, reinforcing the case for broadly diversified investment portfolios.
This is a further argument in favour of using derivatives to receive coupons and approach government bonds as a source of excess returns instead of cash-flow-matching instruments.
Active management of global sovereign bonds can help derive returns from the current steep-term structure of rates and relative value across markets and yield-curve sectors.
Careful monitoring of currency basis swaps should also enable managers of pension assets to identify mispricing in cross-market trading, effectively building synthetic bonds in the reference currency for the pension fund.
In addition, the increased regulatory burden on banks has encouraged a shift towards more market-based financing in Europe and fostered the development of non-bank loan markets.
Pension funds are well-positioned to benefit from secured loan opportunities or private placements of corporate bonds. These assets are less liquid than most fixed income instruments and, as such, offer attractive yield premiums for financial institutions with long-term liabilities.
Despite central banks supplying large amounts of reserves to the financial system, many parts of bond markets remain quite illiquid as banks wind down capital-intensive market-making activities.
For instance, asset swaps of index-linked bonds – transforming linkers into synthetic fixed coupon bonds – provide 30-40 basis points yield premia over comparable conventional UK gilts.
Illiquidity is also a concern in corporate bond markets and therefore a source of yield enhancement. Credit spreads account for up to 75 per cent of total yield to maturity in continental European markets at present.
Lastly, although pension fund liabilities are long-term in nature, solvency is highly dependent on short-term market gyrations. Business cycles and monetary policy decisions have a considerable bearing on performance. Pension asset managers need strong research capabilities to extract allocation value from cyclical market rotations.
Olivier de Larouziere is head of interest rates at Natixis Asset Management
