Two apparently contradictory trends characterise the fixed interest arena – on the one hand there is the move towards specialist bond mandates promising alpha; on the other is the emergence of a paradigm shift among pension funds to match liabilities.
For pension schemes, interest rate sensitivity will be far more significant than any extra drop of outperformance. But in the UK, liability driven investment (LDI) is also gathering momentum because of the regulatory backdrop to funding rates, solvency, contributions to the Pension Protection Fund and frequently the sponsor’s need to strengthen its balance sheet for merger and acquisition activity.
Despite huge interest in the subject, uptake and implementation has been relatively slow. One reason is trustees can find the strategy complicated, requiring four or five client meetings rather than a single beauty parade. For instance, the London Pensions Fund Authority’s cashflow matching mandate, which is split three ways between ECM, Insight and BGI, was implemented in January, having commenced its review back in March 2005.
There were less than five LDI providers in the UK only two years ago, but today there are at least 16, which are putting a great deal of resources into beefing up their offerings in anticipation of strengthening demand.
Narrow LDI
Two schools of LDI are emerging. The first has been called narrow LDI and involves matching future cash flows to a scheme’s needs as closely as possible using traditional bonds. The weakness of a narrow strategy is that maturing pension liabilities move closely with market interest rates and future inflation, and so a set of assets that share the same sensitivity to interest rates as the scheme’s liabilities will not reduce risk.
Finding traditional bonds that do the job at the right price is also difficult. At 4.1 per cent, the yield on long gilts is a pittance. Matching is poor because the longest bond is usually around 30 years, and so will not extend far enough into the future, which in turn will create lumpiness in the cash flows generated. Matching liabilities with conventional fixed income will also do nothing to boost a scheme’s funding level.
Broad LDI
Alternatively, broad LDI involves the use of swaps to offer the prospect of a higher return, and will therefore set an outperformance target to help an underfunded pension scheme take controlled risk, expressed perhaps as a match with any change in the liabilities plus 2 per cent a year.
This is now achievable because of increased liquidity in the swaps market, which has grown 20-fold since 2000. Watson Wyatt predicts that the inflation-linked swaps market in the UK will more than triple this year to £9bn on demand from pension funds. This in turn provides greater opportunity for banks to sell sufficient product at sufficient profit, and heralds the critical mass to target resources to this space.
“LDI is less about matching, and more about increasing sophistication in the use of derivatives, allowing the manager to engineer better portfolios,” says Hugh Cutler, managing director, strategic accounts at BGI. “If five years ago you had said to a trustee that you were going to invest in commodities and derivatives, he may have been alarmed, but many are now comfortable with these concepts. However, trustees are not generally aware of how much risk they are taking in inflation and interest rates. These are probably their biggest risks, beating mortality into third place and equity risk into fourth. Increasing transparency of data in fixed interest at the moment is also helping trustees to understand these issues.”
“So fixed interest is now much less likely to be a static allocation and much more likely to be about allowing managers to use their entire skill-sets,” adds Mr Cutler. “The spreads on emerging market and high yielders are tight, but there is still value to be found, and an unconstrained manager can also bet against names in these sectors.”
The market is awash with pooled funds for small and medium-sized pension schemes to adopt an LDI strategy without the cumbersome legal, collateral, and counterparty risk issues normally encountered. Some funds offer alpha-generating overlays, such as the State Street fund that delivers protected cash payments linked to the projected limited price indexation (LPI) liabilities at the maturity of each of a series of LPI swaps. Not surprisingly, LDI is often presented as a product-based solution when it is essentially a framework for setting strategy.
“We will continue to see a very big trend in bespoke bond mandates that target duration and reflect cashflow requirements, possibly tied up against pensions in payment,” says Robert Hayes, head of strategic advice and solutions at Merrill Lynch. “At the same time the debt markets are being seen as an opportunity space – inflation-linked securities, collateralised debt obligations (CDOs), the freedom to short, and all kinds of exciting things.”
Mr Hayes adds: “The central point is that benchmarks will be bespoke. If you think about changes in the Plus15-Year Gilts index, because the component maturing in 2021 is dropping out, its duration is becoming more than one year longer. This means that any client using the index as a benchmark has been moving into longer-dated stocks. Indices are changing around all the time and are not neatly tied into the requirements of clients.”
“This greater focus on more bespoke strategies all leads to the use and increased acceptance of derivatives. So in the evolution of bond mandates, credit came first, followed by currency hedging, then high yield and emerging market debt, and then exposure to those areas through derivatives. Some are now using interest rate swaps for better tailoring of interest rate sensitivities to liabilities, and credit default swaps to get exposure without holding names.”
Ian McKinlay, head of the investment team at Aon Consulting, agrees: “Where the big move has happened is the use of long-dated swaps. This was a seismic shift and is still taking place but it is very expensive and schemes use it primarily because they feel they have to.” Often, the driver is positioning in M&A activity. “A private equity firm will itself be sensitive to interest rates, and so may want to take out the target’s interest rate risk. And of course the Pensions Regulator has his nose in all of this,” adds McKinlay.
Bond shift
In contrast, the focus on achieving greater alpha from bond mandates is partly driven by the sheer growth in the bond portion of portfolios in recent years, so making every basis point more significant. Access to a diverse opportunity set able to produce high alpha continues to fuel take-up of global aggregate products, and the abandonment of the artificial split between the UK and overseas. Separate mandates focused on domestic benchmarks in the UK, US and Europe continue to be replaced by one international mandate, just as the artificial UK/overseas split has been discarded in equity holdings.
But unlike equities, the use of broader indices used to measure aggregate portfolio performance has made it harder to outperform the index compared with traditional gilt mandates, where a manager could always pump up the returns with the occasional high yielder. This has led to a search for managers who add superior analysis or a superior process.
Pockets of specialist expertise are maturing, particularly in certain small emerging markets such as Hungary, Mexico, Russia, the Philippines and Israel, which are starting to exhibit their own dynamics and are becoming less influenced by outside forces. Other specialisms have become substantially occupied by hedge funds, particularly those strategies that have been likened to picking up dimes in the path of a steam roller, producing small but steady returns that are usually leveraged.
Smaller players may make a virtue of being sufficiently nimble to exploit such markets and will claim that firms managing anything in excess of £135bn to £163bn find it difficult to take positions because the scale is lacking. Big strides in understanding risk management are also influencing the shape of bond portfolios as managers attempt to identify and tap into diverse, uncorrelated returns.
“What we are finding is that clients are looking for better risk-adjusted returns – they want their assets sweated but not at the expense of risk,” says Stephen Millar, consultant relations manager, EMEA, at T Rowe Price. “Much greater attention is being paid to information ratios and Sharpe ratios, and checks to ensure the risk budget is being used efficiently.”
“It is possible to hit a high alpha target,” adds Mr Millar, “but this may be by taking risk which is not optimal for the client, and the aim should be to achieve the same performance target for less risk. For larger managers, what that can mean is ramping up decisions that can be made across all portfolios, such as increasing their positions in relation to duration calls, and the downside is that the risk is much greater.”
“As with equities it would be foolish to suggest there is one template that best delivers these specialisms,” says John Gillies, senior consultant at Frank Russell Company. “The key is whether the product being offered is something that requires resources beyond the scope of that particular manager. If the process really needs 85 analysts, then the long-term validity of that approach may be questionable. In contrast, the shorter decision-making tree in a small boutique can make sense where the process is about understanding in detail information from a small number of sources, perhaps where the mandate is purely gilts for example. The ability to process the information is important,” adds Mr Gillies. “More information coming in than can be processed is a feature of some organisations, just as it can hamper individuals.”
Picking stocks will become more critical in the tighter market. “Many higher return strategies are a play on asset classes like high yield that may falter,” says Malcolm Jones, investment director, fixed interest at Standard Life. “The high yield default cycle may be turning and while our view is pretty positive about the global economy, the market will be a lot tougher, with buybacks and dividends also putting more pressure on the balance sheet. At the moment there are just one-off stories in credit, such as BAA, rather than a systematic aversion to it, but we expect more defaults in next couple of years.”
