By Euan MacLaren
The past few years have seen an increasing focus on de-risking among defined benefit pension funds as they look to reduce risk and prepare for an eventual buyout. However, trustees must understand that the growth part of the portfolio remains crucial.
Achieving a 100% funding level does not mean a scheme has successfully de-risked and the growth portfolio can be set aside. Matching portfolios reduce the risks however the growth portfolio continues to play a role to protect the funding level. Should a scheme be looking to move to buyout then funding levels of in excess of 120% are often required to make buyout a feasible option and it is the growth portfolio that will enable trustees to achieve this.
When it comes to constructing growth portfolios, investments that can provide risk-adjusted returns appropriate to the individual scheme – most commonly associated with active management – are key. And while actively managed equities have received much of the recent attention, there are an increasing number of actively managed fixed income solutions available that can generate attractive returns at appropriate levels of risk, despite the long running bull market in the bond sector.
Even as interest rates look set to rise for the first time in many years, fixed income can play a key role, as a number of opportunities are being created by this changing environment. However it is active managers, who take a less constrained, high conviction approach to fixed income investing, that will be best placed to exploit these. Active managers also bring diversification benefits, as their less constrained approach allows them to diversify across asset class, credit quality and sector.
One of the first places to look when considering actively managed fixed income investment strategies is the absolute return sector, which can help pension schemes ensure returns in a rising rate environment by being more flexible in terms of duration and overall selection of credits.
High yield debt is an attractive option as it can offer both income generation and capital appreciation plus low correlation with other fixed income investments, making it a useful tool for diversification and reducing overall portfolio risk. While high yield can be considered higher risk than other types of debt, choosing a manager who has extensive experience in the high yield arena and takes a thorough approach to research and credit analysis of both the underlying credit and its risk can help to reduce this.
Bank loans are another compelling addition to fixed income portfolios, as they offer a higher yield than investment grade bonds, but take a higher position in the capital repayment structure than high yield debt therefore reducing risk. Similarly to high yield, they also have low correlations with other assets, meaning they offer strong diversification benefits. What’s more, many loans are reaching maturity meaning that they will require refinancing. Previously this was the domain of banks and CLOs, however, due to regulatory change, they now have less capacity for this asset class. This presents a huge opportunity for pension funds and other institutional investors to step in and refinance with favourable terms.
Despite the recent volatility, emerging markets continue to offer attractive opportunities, but it is important to focus on a manager that can identify and exploit these across the market cycle. While emerging markets can carry more risk than their developed counterparts, investing in emerging market debt allows pension funds to access higher yields, while adding another level of portfolio diversification.
Finally, multi-asset credit funds are seeing increasing amounts of interest from pension funds and other institutional investors. These funds combine all of the above into one offering, enabling investors to tap into the returns of the underlying fixed income asset classes, while enjoying maximised levels of diversification.
Despite funding levels being healthier than they have been for some time, trustees must remain vigilant. The growth portfolio should continue to play a key role and this is not simply the preserve of equities. Trustees should consider a more creative growth investment strategy that incorporates both equities and actively managed fixed income investments, despite a less benign environment for the latter. By taking a broader approach when allocating to growth assets, trustees will be better positioned to reduce their scheme’s deficit and meet their overall long-term funding objective.
Euan MacLaren is head of UK/Ireland institutional business at Natixis Global Asset Management
Comments