Falls in gilt yields - driven both by quantitative easing and investor demand for ‘safe haven assets' - have contributed to pension scheme liabilities and deficits rising to near record levels.
As a result, many schemes are looking for alternatives to low-yielding gilts and ways in which to increase returns on the growth assets in their portfolio.
This panel looks at some of these issues.
Taking part in this panel are:
Aviva Investors
Paul Sweeting, managing director and European head of strategy at J.P. Morgan Asset Management
1. Is now the time for schemes to be reducing their exposure to UK government bonds? What are the pros and cons of such an approach?
Aviva Investors: Fuelled by quantitative easing and the sustained demand for ‘safe haven assets', the last decade has seen a tremendous shift toward fixed income assets at the expense of equities. However, with gilt yields remaining at close to record lows, we expect to see the same kind of migration away from UK-based fixed income assets.
One of the big "pros" to this is the potential to address the growing scheme deficits that have been partly brought about by such low gilts yields. This is a good reason to reduce gilt allocations now while prices are still high and valuations in alternative income-generating asset classes remain compelling.
The biggest potential "con" is the risk that the global economy takes another turn for the worst, impacting the valuations of risk assets while pushing up demand for gilts once more. Consequently, schemes considering a reduction in their gilt allocations should model the potential impact of such scenarios before making any major allocation changes.
Paul Sweeting: Calling the top of the gilt market is difficult - however low yields are now, it is always possible that they could move lower. However, as yields fall the potential downside from not being in gilts also falls. At the same time, the prospective return available from gilt investment is similarly constrained.
Many other fixed income asset classes offer consistently higher levels of income that UK government bonds. For higher quality investments, the volatility of these income streams is often no greater than the volatility of the income from a gilt portfolio. Market values can be more volatile - a flight to quality can see credit spreads increase substantially - but this is not always followed by a fall in the level of income.
Market value volatility should also be viewed in the context of pension liabilities. If pensions are discounted using a rate derived from gilt yields, then anything other than gilts will present a mismatch, at least in the short term. However if the focus is on a corporate bond-based measure, such as that used in accounting valuations, then corporate bonds provide a better match that gilts in any case.
2. What low-risk alternatives are there to gilts? Should pension schemes be looking at increasing corporate bond holdings, looking towards emerging market debt or assessing real-assets such as infrastructure, sustainable property, timberland or agriculture? Are there other areas schemes should be looking to?
Aviva Investors: We've already seen strong flows into emerging market and high yield bonds where returns should remain sound, if more volatile. However, the burgeoning demand for low-risk income-generating assets has created a new appreciation for real asset investments.
With around £153 billion of maturing UK real estate debt due for refinancing in the next five years even as banks retreat from the market, the sector offers an attractive opportunity set. Senior debt funds can potentially deliver secure medium-term income streams of around 3 per cent over gilts. In addition European mezzanine debt deals offer cash yields of between 8 per cent and 14 per cent.
However, thanks partly to its strong inflation-matching credentials, the area in which we're seeing the greatest interest is in real assets such as ground rents, social housing, infrastructure, commercial and student assets. This is because they have strong cashflow matching characteristics and provide secure, long term and index-linked returns significantly in excess of those available from index-linked gilts. Such investments also appeal as they're often structured as fully amortising investments. This mirrors the profile of pension liabilities - as another slug of capital at the end of a liability profile serves little purpose - and removes the risk of capital value volatility at the end of the lease as, by then, it has no value.
With bank lending to such sectors waning, pension schemes are being presented with a growing array of such opportunities and we expect real assets to play an increasingly important role in future fixed income allocations.
Paul Sweeting: It's important to look at what we mean by "low risk". If we are talking about risk relative to the liabilities, then the way in which the liabilities are valued is important. For fixed income, any spread between the interest rate used to value the liabilities and the yield on the bonds results in funding level volatility. In this sense higher quality investments, such as investment grade corporate debt and hedged investment grade emerging market debt, are more attractive. Real assets are different: whilst bond values are essentially defined by the discounted value of their cash flows, the same relationship does not hold for investments such as infrastructure and real estate. Here, the link between market value and income is less well defined, meaning that funding level volatility will inevitably be higher.
However, if pension schemes can look beyond short-term measures of volatility, the levels of income from these asset classes gives a different view of "risk". The income from a diversified portfolio of investment grade corporate debt is no more volatile than that from a gilt portfolio. The same is true for investment grade emerging market debt, issue by both governments and corporate. There are also sound fundamental reasons to shifting to these asset classes. Developed market companies have been deleveraging for several years now. This can only be a good thing for the debt that is still outstanding. In emerging markets, companies are increasingly driven by domestic demand, meaning that they offer useful diversification from developed market debt. Furthermore, the strength of emerging market economies has left governments in these countries in far a better fiscal position than developed market contemporaries - in other words, the debt of many emerging market governments looks much more secure than many developed market government issues.
The income from real assets is inherently more volatile. However, they have one key advantage over most fixed income investments, and that is that the income is more likely to increase over time. Increases are likely to be linked to inflation, implicitly if not explicitly. This makes them a useful to pension schemes, where a significant part of the liabilities is inflation-linked.
3. To what extent are strong gilt yields contributing to a revival in the fortunes of developed market equities?
Aviva Investors: Markets have recovered over the last year with the FTSE All-Share up over 20% and global equity markets up by around 18%. However, while corporates are healthier than in 2009, we believe the market recovery is now being driven more by quantitative easing than the underlying economy.
At this stage of a low-growth recovery, higher-yielding equities remain an attractive investment proposition. We think there are compelling investment opportunities both in the UK and overseas. 90% of stocks yielding more than the UK market are based overseas, many of them representing good value
There are a number of successful global equity income solutions now available offering dividend yields of around 5% p.a thanks to portfolios which include true global leaders from every sector. Because of the strong franchises these companies enjoy and the fact that they often specialise in supplying more staple needs - from household goods through to pharmaceuticals and energy - they boast extensive cash flows that are insulated from the worst ravages of recession, as they can pass inflationary increases on to their customers. As a result, they are growing their cashflows, and even with increased dividends their payout ratios remain at historic lows, suggesting there is scope to return yet more cash to shareholders.
Paul Sweeting: Rising yields clearly make developed market equities look more attractive and increase interest in this asset class. However, the market is more interested in the potential future income stream as yields driven by historical dividend payments. The outlook for future dividend payments is driven partly by past levels, since firms aim to increase dividends and are reluctant to reduce them. However, the long-term outlook and the prospect for future dividend growth is inherently uncertain, and small changes in these expectations can result in large changes to share prices. And, of course, the ebb and flow of sentiment on global macro-economic issues has a direct impact on share prices.
