The panellists discuss if pension schemes should be upping their allocation to fixed income, the ramifications of the budget and the 100-year bond
Kames Capital joint head of fixed income Stephen Jones
Principal Global Investors managing director fixed income Jon Taylor
- Should pension schemes be considering allocating more funds to fixed income assets at the current time?
Stephen Jones: We believe that pension schemes and their advisers should be paying attention to the interest rate risks they are carrying. However, at current market levels, one has to question whether it is the right time to be adding interest rate exposure through gilts or interest rate swaps.
Yields will rise as the economy recovers and the European debt crisis eases, but we do not expect this to happen as rapidly as many pension schemes might hope.
The economic recovery will be weak, given the fiscal austerity underway and the fact that banks have limited lending capacity to stimulate the private sector. This will keep interest rate expectations muted which, in conjunction with a likely extension of the Bank of England's asset purchases, will continue to support the gilt market.
For the majority of schemes that have suffered as yields have fallen, there is merit in attempting to ride this period out if their sponsors remain supportive. But as yields rise and funding levels improve, we would strongly advocate that schemes incrementally close-out their short duration positions.
It should be recognised there is a wide range of assets covered by the umbrella ‘fixed income', and each offers investors opportunities at different points in the market cycle.
On a long-term view investment grade credit continues to offer attractive opportunities relative to government debt. In the non-financial space, many corporates have strong balance sheets.
Financial companies continue to face challenges as they also look to strengthen their balance sheets. However, they are well supported by governments and central banks and their bonds offer attractive yields.
High yield bonds continue to offer an interesting opportunity, and one which has been underutilised by pension schemes. We believe high yield bonds can be a valuable component of a growth asset portfolio. They have very low correlation with government bonds and also provide diversification from equities. They typically perform well during the early stages of economic recoveries, when companies prioritise the repayment of debt. Even after the strong returns of the last three years, valuations remain reasonably attractive, particularly given low default expectations.
Given the demonstrable benefits of a flexible asset allocation in recent times, we have seen a significant increase in demand for unconstrained global bond strategies. These strategies allow us to add value for our clients' from across the fixed income universe.
As with high yield bonds, pension schemes have been relatively slow to adopt this approach to fixed income investing.
Jon Taylor: At the present time, Gilts are singularly unattractive. Yields are at historic lows having been driven down by a massive financial crisis and global risk aversion.
Indeed, in many countries, relaxed monetary policy and aggressive quantitative easing has been specifically designed to artificially depress yields and allow economies to recover. This has certainly been the case in the UK, where the Bank of England has been very proactive on the policy front despite relatively high headline inflation.
Current yield levels are not sustainable and will inevitably return to more normal levels guaranteeing capital losses.
At current levels, investors are not protected from the inevitable erosion of real capital due to inflation. This is true even if the Bank of England is successful at meeting its stated long-term objective of maintaining inflation in a 2% band centred on 2% per annum.
If, in fact, a pension scheme is compelled to add to fixed income assets due to asset and liability management considerations, then there are options considerably more attractive than Gilts. Global bonds provide a distinct advantage over a single country investment strategy.
A global strategy opens up a plethora opportunities. Divergence in country economic and monetary policy cycles affords pension schemes better options and enhances the prospects of capital preservation and yield enhancement. As such, higher expected returns are possible at lower overall risk levels.
Another attractive alternative is an investment strategy incorporating significant exposure to corporate credit. The yield advantage offered in corporate credit is considerable. As the global economy moves toward sustainable growth in the post-recession environment corporate credit will provide good risk-adjusted returns.
Again, a global perspective affords a broader opportunity set than a single country approach.
While an argument might be made to duration-matching assets and liabilities in a pension scheme, there are other more attractive alternatives than Gilts.
