Roundtable: How can schemes prepare for uncertainty in fixed income?

Edward Farley: Our outlook is for rates to remain low for a longer period of time. In the US, the Federal Reserve raised rates in March, and we are expecting two or three more rate hikes this year, and more hikes next year.

However, short-term rate increases do not necessarily mean that long-term rates will go up significantly, if at all. In the UK, 10-year rates are around 1.4 per cent; the market expects a rate hike in May, maybe one more later in the year and, depending on who you listen to, one or two next year.

However, a lot of this will be impacted by Brexit and the UK economy. Although there is room for rates to go up in the UK, I do not think it will be a seismic shift.

In Europe, rates will likely increase at an even slower pace. The first rate rise in Europe is expected in mid-2019. Ten-year rates are much lower in Europe, and again, they clearly have room to go up.

So I think we will see some rate increases, but there should not be enormous shifts higher.

Sophia Heathcoat: Like Ed said, so much depends on economic conditions. Let us remember that markets are expecting rate rises to happen, they are priced into the curve, so it is whether or not there are any shocks or surprises.

In terms of pension schemes, the focus should be on liability-driven investment, managing rate risk and improving the matching between the assets and liabilities. That then allows them to look at opportunities to pick up spreads within the growth portfolio.

Dinesh Visavadia: I know we know the planned trajectory of interest rate rises.

However, the governments in these countries have a lot of debt that they need to finance. They also have ambitious plans to finance some of the public spending programmes, as well. I just wonder to what extent that might accelerate the interest rate cycle.

Alexandra Martinez: I am with you on this one. I think the rates in general are not going to affect any defaults in corporates, so I do not see that as a risk.

But if the US are going to issue almost $1tn (£716bn) in sovereigns, who is the target market? There is no more quantitative easing, so the Fed is not going to buy it. I would be a bit more worried about that.

As for how schemes should react, I agree: cash flow matching, liability matching and doing so in an affordable way, because active LDI tends to be extremely expensive and is not always very efficient.

Graham Wardle: So many DB schemes now are trying to derisk and move to buy-in or a similar goal. That will continue to hold down rates at the long end, I think.

Pensions Expert: Are schemes under or overhedged against interest rates?

Martinez: Underhedged, unfortunately, but what is the right rate? Is it 40 per cent, is it 60 per cent?

Anthony Fletcher: Of course, it depends where your pension fund is in its lifecycle. If it is getting towards the end of its life, or if the finance director has a very strong desire to sell it off to an insurance company, then liability matching is a good idea. However, open schemes might have a rather different time horizon.

Visavadia: One of the tensions that I am finding is that maybe if you look at the advisers to the corporate world, they are very optimistic in terms of the direction of travel of the interest rates. They are always pushing back on hedging.

Wardle: The cash flow matching point is really interesting, actually, because that is clearly going to be the next step for a lot of pension schemes. That is where fixed income comes in handy.

Visavadia: However, the yield compression and uncertainty in the economic backdrop is not helpful for trying to get into cash flow-driven investments at the moment.

You might get away with it in the next few years, with a buy-and-hold approach, but you need to think about what you do after that.

Farley: You can always argue that for the last three or four years there were more attractive entry points.

Looking at long-end spreads, one could ask, ‘Do they compensate for default risk?’ I would say absolutely, if you take a really long-term picture.

We could then ask, ‘What am I discounting my liabilities around? Do I have a reasonably defensive way of outperforming those discounted liabilities with corporates?’ Again, the answer could be yes. Maybe there will be more attractive entry points in the future, maybe there will not.

Some schemes may decide to have a shorter duration and match a lot of their shorter cash flows with corporate bonds. I am more comfortable that we are going to be in a low default environment in the short term, and therefore are more comfortable with credit risk. An LDI manager can do the longer-term investing, and the scheme can grow into it.

I do not think there is necessarily a right philosophy. What we have tended to find is that the better funded a scheme is, the more they want to lock down the whole jigsaw puzzle.

As long as they are selecting bonds that are unlikely to default and are considered solid credits, they can do cash flow matching and earn a little bit of extra yield, without taking that much risk. They can invest the bulk in good-quality corporate bonds and then invest tactically to add extra alpha.

Fletcher: I think that is exactly the issue. If you are using government bonds, you have that interest rate risk. If you are in other kinds of assets, such as corporate bonds, or high yield or private debt, these assets tend to have greater spreads and they also tend to have shorter durations. The durations are short enough that if you have a surprise move up in government yields, you can allow those bonds to mature and then re-enter the market. That is a real opportunity, given where we are in the cycle.

So even if you do not know for sure that long rates are going to go up a lot, you have this opportunity to recycle those higher spread product yields. That is something that I am seeing not just in the Local Government Pension Scheme but also in the corporate space: their government bond exposure is extremely low.

That brings us back to the question of how we are going to find the money for this doubling of net treasury supplies that we are going to get this year because of quantitative tightening, and the supply of bonds to pay for fiscal policy. So for me, all of the pressure is in government markets, not in spread markets, at the moment.