How UK schemes are approaching fixed income in uncertain times

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At a glance:

Fixed income allocations by UK schemes continue to rise
Cashflow-driven investment is becoming increasingly popular
But schemes should be cautious of the credit risk they are taking
Defined benefit schemes are taking fresh approaches to liability-matching and repositioning their return-seeking investments, says Alastair O'Dell.

Fixed income allocations are changing at an accelerating rate as defined benefit (DB) pension schemes tackle the shift to becoming cashflow negative, while dealing with low yields and an uncertain credit outlook.

A Mercer study of its European clients in June found 56% of plans are cashflow negative, up from 50% last year. Of the remaining 44%, half are expected to become cashflow negative within five years. "The pace at which schemes are maturing and becoming cashflow negative is accelerating," says Mercer director Wayne Davidson.

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Willis Towers Watson investment director Kate Hollis agrees: "The balance between return-seeking and liability-matching is changing as schemes are reaching full-funding faster than they were anticipating. They are de-risking, funded by sales of return-seeking assets of all types."

Liability-driven investment

DB funds invest in fixed income to match liabilities and make smaller allocations to return-seeking assets. Mature schemes may be fully hedged while others remain in risk assets and use liability-driven investment (LDI) to pay pensions.

The Pension Protection Fund (PPF) has a strong funding position and is on track to be self-sufficient by 2030. It invests 40% of its assets in LDI to match all of its pensioner liabilities.

PPF head of investment strategy Ian Scott says: "We do it in a very precise way - an expert team runs a portfolio and effectively hedges all of our interest rate and inflation liabilities.

"I'd be surprised if many schemes are as precisely hedged as us. To stress test the portfolio we run scenario analysis. For the role we perform it absolutely makes sense to hedge our liabilities, with a growth portfolio alongside."

Cashflow-driven investing

Cashflow-driven investing (CDI) has emerged as one approach available to schemes - and is touted as being of particular use to schemes that have become cashflow negative.

Pensions and Lifetime Savings Association (PLSA) policy lead for investment and DB Caroline Escott says: "More schemes are thinking about, or moving to, CDI. The bond mix can include gilts, investment grade credit as well as high-yield debt. Within high-yield, emerging market debt is becoming increasingly popular for UK schemes - which have been slower to invest than schemes elsewhere in Europe."

Redington senior vice-president for manager research Greg Fedorenko adds: "The idea is that you can be agnostic to mark-to-market changes in valuation. Implemented correctly, it provides confidence you won't be forced to sell at depressed valuations.

"However, we have major reservations about how it is being marketed. There are physically not enough sterling investment grade corporate bonds needed to theoretically match all UK liabilities as they fall due. The total outstanding amount of credit is way, way smaller. There is an inbuilt demand/supply imbalance."

Royal Mail Pension Plan (RMPP) chief investment officer Ian McKnight agrees: "CDI is a bit of a sales pitch. It's a good idea conceptually but the name suggests it is something new. It's not, it's just LDI that more accurately matches liabilities over a shorter time horizon."

Interest rate risk

Another trend is that most pension schemes are not fully hedged and are looking to increase coverage due to the effect of small changes in interest and inflation rates on their liabilities.

As Capital Cranfield director Joanna Matthews explains: "The effect of interest rate and inflation risk is usually disproportionately large for pension schemes and most feel that leaving liabilities un-hedged is too big a risk."

The expectation is for short-term rates to gradually rise. If they do, it is likely there will be a net funding gain - and Mercer's Davidson says, in this scenario, for an average scheme, with a reasonable 60-70% hedge through a leveraged LDI position, liabilities would, most likely, be falling faster than assets.

Rising rates would, he warns, create an issue that needs to be monitored. "With LDI losing value, collateralising the mandate is likely to mean selling other assets," says Davidson.

If a trustee board expects rates to go up, it should invest in short duration bonds and roll the flow of coupons and redemptions into new ones, hopefully at higher rates. If not, the scheme can be more relaxed and get paid for duration risk.

Ultimately, however, the RMPP's McKnight says that trying to predict how interest rates will change in future is a "gamble". He says: "You need to accept the reality that promising a pension today is expensive. If you don't hedge it, you are simply gambling that it will be cheaper in the future were rates to rise."

Credit risk

Another risk - and one that is often underestimated by trustees - is credit risk.

PTL managing director Richard Butcher explains: "The risk not considered as seriously as it should be by trustees is default risk. The more debt you own in your portfolio, the more exposed you are."

Pension schemes have bought the bonds of blue-chip companies "to a relatively high extent". However Butcher says: "But many apparently low-risk companies have collapsed - Equitable Life and Lehman Brothers were once blue-chip.

"Brexit could have a very significant impact on the UK and European economies and companies - to their severe detriment. Pension schemes need to recognise this - then consider whether they can and should mitigate it."

Critically, credit risk includes the effect on the scheme covenant. "The effect on the scheme sponsor has got to be the biggest risk, especially if there is a deficit," adds Butcher.

Return-seeking assets

Pension schemes also need to consider esoteric options to achieve attractive yields without accepting high levels of credit risk. "For return-seeking assets, we think there is much better value in private and illiquid debt than in traditional credit," says Willis Towers Watson's Hollis.

Capital Cranfield's Matthews adds: "There is a need to find better returns without being too reliant on equity-like investments. It's now easier for pension schemes to access more unconventional fixed income products."

However, there is a broad church of debt to pick from. As RMPP's McKnight says: "Recent years have been a boon in the UK for products such as multi-asset credit - which is usually convertibles, high-yield and emerging market debt - but you can go even broader."

Nationwide Pension Fund chief investment officer Mark Hedges says: "We have 5% of the fund in a multi-asset credit fund. We also have a mandate, exposed to investment grade tranches of collateralised loan obligations, which pays more than corporate bonds and has more robust default characteristics.

"We also invest in real estate debt and direct credit through illiquid funds in our private market portfolio. Over time, as we de-risk the fund, we would expect that private market illiquidity premium to shift to more income generating activities."

Mercer's Davidson notes that secured finance combines asset-backed securities and senior private debt as an alternative to investment grade bonds. He explains: "The idea is to package up liquid and less liquid credit, investment grade or equivalent but with longer duration and less liquidity to enhance yield. That's a big trend."

Likewise, direct lending has also attracted a lot of money, from senior and mezzanine loan tranches, through to distressed esoteric debt, according to RMPP's McKnight.

However, PTL's Butcher says it is dangerous to think of these diverse asset types as a homogeneous asset class. He says: "The real risk is we haven't seen these things tested under severe economic conditions - they were not mainstream before the crisis."

He adds: "The thing that amuses me is that investment consultants turns up with ever more esoteric investments. We are obliged to be constructively skeptical."

Illiquidity premium

Pension schemes can also boost returns by seeking an illiquidity premium, if it fits with the scheme's maturity. "Even within this maturing DB space, the time horizon means illiquidity can still be the pension fund's friend," says Mercer's Davidson.

But schemes need to make sure they are being amply compensated for this risk. "A sea of money has piled into illiquid debt," says RMPP's McKnight. "The spreads have tightened across everything, which has called into question whether there is value in the illiquidity risk premium."

PPF's Scott agrees: "The scale of the liquidity premium is a lot smaller than it used to be. It's opaque - people attempt to calculate the premium but it's not straightforward."

Even in pooled funds, severe stress may mean outflows are restricted. "When you have the most acute need for liquidity, your ability to liquidate it would be compromised," says PTL's Butcher. "You have to accept that as a risk - it's why you get a premium."

Willis Towers Watson's Hollis adds: "Where you are [on the road to buyout] will affect the liability-matching assets you can buy. In the private debt arena, there are things pension schemes can buy that don't work well for insurance companies, for regulatory and capital reasons."