FT Mandate: Stockmarket volatility returns, UK bond yields rise off their near 4 per cent lows and all of a sudden there are many pension funds and their consultants asking whether their decision to hold off transferring assets from equities to bonds should be reviewed. So, what is your position and what does your crystal ball say should happen in the next 12 months?
Craig Hurt: No one has all the answers but Investments 101, [a US-based investment club] says that over the next 30 years equities will surely outperform bonds. Why? Well, irrespective of what happens to inflation or growth the best you will get from a bond investment now is 4 per cent to 5 per cent. If equities don’t do better than that then we have a tough 30 years ahead of us.
So, should UK pension funds be investing primarily in equities? Not really, because pension fund investing is no longer about choosing the asset that will provide the greatest return over a particular period. Nor is it about rational economic sense but rather risk mitigation and solvency levels. Pension funds now need to invest in assets that provide them with a cashflow profile more akin to the liabilities in their pension funds.
And what is the primary asset that gives us that cashflow profile? Bonds. Today, we hear a lot of talk on the issuance of 50 year bonds, growth of the credit market and credit derivatives which have been around for several years, though they are only now becoming the new sexy game in town.
FTM: What makes bonds so attractive and can the bond market handle the demand?
CH: Bonds have certain characteristics that pension funds find useful: security, liquidity, transparency and importantly duration. Asset managers are often asked whether the bond market has sufficient depth and liquidity to deal with this increasing demand. Well, the gilt market is around £330bn*, the sterling non-gilt market around £367bn* and the index-linked market around £123bn*. Given that the size of the UK pension fund market is around £900bn,** the bond market seems more than able to accommodate all the recent flows into bonds and out of equities. What has been interesting to note over the last few years is the growth of the credit market, as more and more corporates have taken advantage of low bond yields to restructure their debt to the point where now the non-gilt market is greater than the gilt market.
It is not just the size of the credit market which is growing but also its complexity. The onset of the credit derivatives market is transforming a once semi-liquid market into the key area of the bond market. Credit default swaps (CDS) represent one of the most important recent developments in fixed income markets. They enable the investment, in or divestment of, credit risk in single name entities. The CDS transaction seeks to separate credit risk from other risks (namely interest rate risk). ‘The protection seller’ agrees to compensate another party ‘the protection buyer’ for the financial loss it may incur following the occurrence of a ‘credit event’ in relation to a ‘reference amount’. The CDS market can provide greater depth and liquidity for sterling fund managers. The sterling fixed interest market has circa 800 sterling denominated issues yet only circa 300 issuers. When looked at in the context of some 2000 issuers currently being priced for Axa Investment Managers by our external pricing provider, the diversification benefit of CDS speak for themselves.
Another area of the UK bond market that is gaining increasing attention is the index-linked market. An index-linked bond provides a return linked to the inflation index hence the term “index-linked”. For many years few UK pension funds invested passively within the UK index-linked market. However, in the last year asset managers have been inundated with requests for the active management of UK pension fund’s index-linked portfolios. Why? Firstly, many UK pensions are linked to inflation and secondly, with yield so low any additional performance one can glean above a particular benchmark is to be taken with open arms. Hence, the many requests for corporate index-linked mandates. So, what does the corporate index-linked market look like?
- The market value is around £12bn*** and has grown by around £2bn*** a year over the last few years which makes one think there is some stock available and it’s a growing market. Nominal issuance however is just over £8bn.
- Supranational issuance (2000–01) followed by water and infrastructure companies (2002-03) were responsible for early growth, whilst the last two years has seen only the Network Rail issue in late 2004.
- 70 per cent of stocks are AAA-rated, with 59 per cent**** wrapped.
- Most of them are long-dated with 75 per cent**** being over 15 years
FTM: What strategies are being put forward by the consulting community and UK pension funds?
CH: We see three broad trends emerging in the UK fixed income marketplace. The first is the requirement for scheme specific benchmarks where the scheme will allocate various percentages to gilts, credit and index-linked debt and then require a duration target between 15 and 20 years. This generally requires the use of swaps and implies a very carefully thought out agreement on the valuation of the benchmark. In addition, it also requires a thorough portfolio construction process so that the tracking error relative to liabilities is minimised. It is often the cleanest method of ensuring that any outperformance on the fixed income portion leads directly to improving the solvency position. However, it can also be very difficult to implement and monitor unless thought out and monitored very carefully.
The second theme is that of diversified sources of alpha. With the growth of the credit market and various other ‘sources’ like currency, mortgage-backed and asset-backed securities, high yield and even securities lending (as proposed by some investment managers) the opportunities to make money for UK pension funds seems to grow by the day. A word of caution though; do not look at each source of additional alpha as a “given”. Each one provides an opportunity to enhance returns but again it’s not just having access to these sources of alpha. The real skill is in the portfolio construction process. How do you blend the sources of alpha? Bond management is not about picking the right stock that goes up two or three times. It is about avoiding losers, finding areas to make money, taking the profit and then looking for the next area.
The third trend is the re-emergence of the core bond mandate after an absence from the market of some two years. In 2003, the investment management community began talking about high alpha fixed income mandates. Not surprisingly this was when credit spreads were still very wide and the accommodative monetary policies were still the order of the day. Halfway through 2004 it became almost accepted wisdom that the only fixed income mandate worth having was one where the manager targets in excess of 1.5 per cent in excess of benchmark. What some people missed was that it’s not that easy to attain those performance numbers when spreads are a lot tighter. Take a look at the performance numbers of a number of those “high alpha” fixed income funds on the market over the last two years and see how they have done.
In the UK, investment managers are generally reviewed after three years relative to their performance targets. A high alpha manager that underperformed by 1 per cent in year 1 (as some did) would need to make back that 1 per cent, the 1.5 per cent they didn’t make in year one as well as the 1.5 per cent for the next two years to have delivered what they “promised” the client. That’s approximately 5.5 per cent in two years and quite a risky portfolio by the looks of things. We are heartened to see the reintroduction of the core fixed income mandate targeting 1 per cent in excess of the benchmark and then by all means supplement it with a high alpha manager if you so choose. But beware of the risk warnings. You, the pension fund, have to pay the pensions. Not the investment manager or consultant.
In summary therefore, the UK bond market is developing quite quickly and in most areas is more than capable of meeting the needs of UK pension funds.
*Source: International Financial Services London 2006
**Source: Bloomberg as at 7 June 2006
***Source: Barclays Capital as at November 2005
****Source: Bloomberg as at January 2006
IN ASSOCIATION WITH AXA INVESTMENT MANAGERS. AXA Investment Managers is a multi expert investment manager, backed and inspired by the AXA Group.
With €432bn of assets under management, 700 funds and 2400 employees across 16 countries, AXA Investment Managers is present across all major asset classes and investment expertises. Its ambition is to offer performing financial products and investment solutions that meet the specific needs of its clients – institutional investors, distributors or the AXA Group.
Its key competitive advantages lie in its multi expert organisation which combines the strength of global shared resources with the reactivity and entrepreneurial mindset of small, empowered teams of experts.
Thanks to its clear and sharp view of financial markets’ main stakes, AXA Investment has established itself as an industry trendsetter and has an active role in driving the industry forward.
