By Ashish Kapur, European head of institutional solutions, SEI
With UK gilt yields at an all time low, many pension trustees are understandably questioning whether their fixed income portfolios are overvalued. Furthermore, those looking to de-risk face the dilemma of whether to move their assets from equities yielding 3.9% (FTSE All Share Dividend Yield as at 19 November) to gilts yielding 1.8% (10-year gilt yield as at 19 November). After adjusting for inflation, these gilts will yield negative real returns, making them more of a return-free rather than risk-free asset.
Given these lamentable market conditions, is now the right time for a scheme to de-risk, and how should a trustee approach asset allocation to achieve growth? While in the short term both gilt yields and equity markets can go lower, ‘safehaven’ bonds such as gilts are overpriced by most long-term measures. If a scheme’s appetite permits, they could look to allocate their portfolio towards return enhancing assets by increasing the allocation to equity assets. The relative valuation of these assets means that investing in assets which back dividend growth or have high spreads could deliver excess return. Should global economic conditions improve, equities should deliver significant outperformance versus bonds but higher equity allocation could lead to higher funding volatility in the meantime. The past 24 months has seen high yield bonds used as an alternative to gilts and although high demand has inevitably led to a decline in yield, this is still a viable option. Schemes looking to de-risk must first ascertain whether they can afford to do so. For some pension schemes, paying the current market price to hold greater bond investments may be worthwhile in order to obtain greater certainty of outcomes relative to their liability. If the strategic rationale allows, then pension schemes should not be dissuaded by the current conditions. However, the current investment markets also offer possibilities to improve the existing interest rate and inflation hedges without increasing allocation to fixed income assets. This may involve slowing the move towards long duration bonds by investing in shorter duration bonds or exploiting break-even inflation to switch nominal bond holdings into inflation-linked bond holdings. Other feasible options for those concerned about rising interest rates and losing the absolute value of their bond investment could be to transfer some of their fixed income investments into an unconstrained or absolute return mandate. An unconstrained approach could offer an enhanced ability to navigate interest rate and credit cycles and as such may offer better protection in rising interest rate and spread-widening environments than a long-only fund. Comparable to unconstrained bonds is the greater use of alternative asset classes to obtain inflation and interest rate exposure while outperforming government bonds. These alternative assets include timber/forestry, infrastructure (with low private equity correlation) or potentially Solar PV panels. Determining an appropriate course for your pension scheme depends on a number of factors including your funding level and risk appetite. But central to any such process is a governance structure that provides for informed, speedy and efficient decision making.
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