In the first of four special reports, we look at how the UK’s leading investment consultants have changed their views of fixed income since the financial crisis
Investment consultants have turned their back on traditional approaches to fixed income since the collapse of Lehman Brothers, a review of the country’s top advisers has found.
Pension schemes have gradually become convinced over the past decade of the merits of using fixed income to match their liabilities. But the fall-out from the 2008 financial crisis has led their consultants to revaluate the risks inherent in the asset class.
The inability of borrowers to repay debt, the flood of capital from central banks and the instability of corporations and nations have led to a reassessment of fixed income and the role it plays in a pension fund portfolio.
Pensions Week and schemeXpert.com surveyed 12 of the highest profile UK investment consultancies to discover how attitudes to fixed income have changed in the past three years and what the future looks like for the asset class.
The survey found consultants are seeking a greater understanding of default risk and also evaluating the factors which lead to changing correlation between different fixed income asset classes. The financial crisis has also created many opportunities within fixed income, which consultants are keen to explore.
Liability matching
Liability-driven investment, which uses fixed income assets to hedge pension scheme risks, was finding favour among many pension funds before 2008. But the financial crisis has convinced consultants just how crucial it is for schemes to effectively manage their liabilities.
“Addressing the asset-liability mismatch has become more important to pension schemes since 2008,” said Karen Heaven, vice president and investment consultant at Redington. “Less well-matched schemes saw their funding levels swing violently – and negatively – with market volatility.
“Widening credit spreads disguised the impact somewhat on the accounting basis – but not the trustees’ funding basis.”
Many of the consultants polled have spent a lot of time warning pension schemes and their sponsors of the dangers posed by ‘unrewarded risks’, such as interest rate and inflation risks.
Index-linked bonds have been a key component of pension fund portfolios where schemes look to manage long-term risk.
But David Clare, managing director at JLT Investment Consulting, warned schemes who use fixed income assets to match their liabilities not to ignore the volatility in the bond markets over the past few years.
“As bond yields fell to historically low levels, bond assets also generated a good absolute return, especially compared to equities,” he said.
“The worry is that trustees and their advisers will use historic performance to set investment strategy, which will increase the regret risk if yields rise in response to an increased inflationary environment.”
Sovereign debt
Consultants have also faced a new spectre in the form of the sovereign debt crisis. The traditional view that developed market government bonds offer a safe haven for investments has been turned on its head.
The survey asked consultants whether this had led them to change their attitudes to government bonds and how they advised their clients on using them.
Most said it had caused them to reappraise the risk of individual countries defaulting on their debt – looking at demographics, fiscal policy, access to natural resources and whether the trade balance was favourable.
For Claire Ballantyne, manager research analyst at Hymans Robertson, the main lesson from the Greek, Irish and Portuguese bailouts has been to expose the risk inherent in any borrower that does not control the currency of repayment.
Matt Tickle, partner at Barnett Waddingham, said he now assesses all bonds on an “ability to repay” basis. He added: “It’s been a reminder that not all A-rated bonds are born equal, just as not all sovereign debt is born equal. You should always ask, ‘Will I get my money back?’”
The consultants now have a much clearer distinction between risky and more stable sovereign debt. Many stated they had not changed their attitude to stronger countries’ bonds, such as UK gilts.
But there was concern that the crisis had kept yields low on stronger bonds, which in turn made them less attractive as an entry point.
The raising awareness of sovereign risk has also led consultants to advise their clients to tighten up guidelines on government bond mandates to ensure greater insulation against a default.
Bobby Riddaway, principal and senior investment consultant at Buck Consultants, said: “The sovereign debt crisis has reinforced the view that government bonds are not a risk-free asset and investment in fixed income carries risks which should be understood rather than just viewing them as a matching asset.”
The financial crisis has led to a greater understanding among consultants of the risks within fixed income. In response they have developed methods of analysing that risk and managing it within their clients’ portfolios.
