Talking head: Redington's Rob Gardner turns his attention to pension funds' fixed income allocations and how to answer their hunger for yield.
For example, National Grid issued an investment-grade bond at gilts plus 320 basis points. If we look at the investment-grade universe, the credit spread that can be earned over gilts has more than halved from more than 300bp to 130bp.
In the context of where yields are today, pension funds need to give managers a less constrained mandate
Given the fall in credit spreads, the expected return from investing in credit is likely to be lower over the next few years.
Yields from investment-grade credit are likely to be too low, except for the best funded pension funds and insurance companies. As we move out across the credit universe a similar picture emerges.
Asset-backed securities, once unloved, yielded Libor plus 485bp – today they yield Libor plus 80bp. High-yield spreads have also come in from Libor plus 1350bp to Libor plus 350bp.
Given the riskier nature of high yield and expected defaults, the net expected return may now be too low for many pension funds.
Despite this, fixed income can still provide attractive yields for many funds. However, simply allocating to long-only investment grade, ABS and high yield is unlikely to generate sufficient returns.
Achieving higher yields requires a more active and dynamic approach to fixed income investing that may include the use of leverage. This results in a higher reliance on fund manager skills, increased need for risk management, investing in more complex underlying securities, and adding leverage to the portfolio. This increased reliance on manager skill and risk management also means higher fees and greater governance.
If you want to find higher yields, investors need to go more complex.
In the context of where yields are today, pension funds need to give managers a less constrained mandate that allows for a more dynamic asset allocation across a broader range of fixed income asset classes and more active security selection, with a greater toolset of bonds, loans, and derivatives.
This leads to more complex and less liquid securities as a way to achieve higher yields. When assessing these opportunities and how they fit within the context of your pension fund strategy, you can use the following framework to compare and contrast investment opportunities:
The yields on both an absolute and relative basis;
The risks, which may include the default risk, level of security, the diversification etc;
The liquidity of the asset;
The fees for implementing the strategy and the complexity and governance of investing in a new fixed income asset class.
Finding yield in fixed income is possible, but requires embracing new securities, in new ways, with a new mindset.
Rob Gardner is co-CEO at consultancy Redington
