Fixed income: It’s not about the money

13 Apr 2021

Warren Buffett says that fixed income has become bad news, but, as Andrew Holt discovers, for institutional investors there is more to bonds than income.

Fixed income is being labelled as the bleak midwinter option for institutional investors. The key culprit in the demonisation of the asset class is legendary US investor Warren Buffett. At the end of February, the chair and chief executive of Berkshire Hathaway warned in his annual letter to shareholders that fixed-income investors worldwide face a bleak future.

The Sage of Omaha noted that the income available from a 10-year US treasury bond at the end of 2020 was 0.93%, 94% lower than the 15.8% yield available back in the heady days of September 1981.

“Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future,” Buffett said. Yet asset owners with considerable liabilities, such as pension funds and insurers, value fixed income as an asset class because of the defined returns such assets offer.

“This statement [by Buffett] implies an environment of steadily rising rates which will erode the value of existing holdings of bonds,” says Mark Hedges, Nationwide Pension Fund’s chief investment officer. “So yes, in such an environment values of exiting fixed income holdings decline.”

However, Buffett has overlooked the key crux in his analysis, Hedges believes. “Pension fund liabilities also fall as rates rise as they su er larger discounts,” he says. “Fundamentally, for a pension fund, much of the holdings of gilts and linkers are not bought for their investment returns, they are primarily about managing liability risks.”

However, Ben Shaw, director at financing platform HNW Lending, believes that other elements of Buffet’s assessment are worth exploring. “The Sage of Omaha indeed has a point in that there are real prospects for inflation in the economy and so those investing in long-term fixed debt may well see not only very modest interest income but also a decline in the real value of their capital,” he says.

There is no doubt that the spectre of inflation is causing unease and eats into real bond returns. “Inflation would erode fixed income, though holdings of index-linked gilts will remain attractive,” Hedges says. It is in this inflationary impact that Shaw has a warning for fixed income’s outlook. “I see more people beginning to realise the implications of the enormous government borrowings and stimulus packages on inflation and therefore in their asset portfolio and taking action.”

“Fixed income, therefore, in my opinion, has further adjustment coming over the next year,” Shaw adds. Such a scenario presents a potentially complicated and challenging picture for institutional investors.

In March, the Bank of England kept interest rates at a record low of 0.1% and decided not to increase the pace at which it buys government bonds, while showing little concern for inflation. At the same time, the European Central Bank increased its bond-buying program from €500bn (£430bn) to a whopping €1.85trn (£1.59trn), which could see some active managers increase their bond exposure.

Although at some points on the yield curve there is a fundamental problem, with yields below -0.7% out to seven years, according Legal & General Investment Management (LGIM). “That means eurozone investors who hold the bonds to maturity can expect a materially lower return than if they just held cash at current deposit rate levels,” says John Roe, LGIM’s head of multi-asset funds.

Different landscape

“There is certainly no free lunch anymore,” is how Anand Kwatra, life and investment actuary at insurer Phoenix, assesses the situation. “The future investment landscape will be very different from the past. Investors will need to learn to navigate an era of low returns and elevated volatility.”

Chetan Ghosh, chief investment officer of the Centrica Pension Schemes, says that in the current environment bond investing should be seen as a long-term strategy. “Low prevailing bond yields mathematically cap the prospective short to medium-term returns available from fixed income and invariably returns from this asset class will likely be low in that time frame.

“The position for UK pension schemes that are well hedged is a bit more nuanced,” Ghosh adds. “The hedging changes the purpose of fixed income assets in the portfolio. Rather than using fixed income to deliver high total return, the investment problem becomes more focused on successful credit spread capture over time. Investors can still seemingly harvest reason- able excess returns from credit spreads at current prices.”

On another measure, in a rising interest rate environment fixed-rate bonds become cheaper, and, therefore, may be more attractive assets to hold. “In addition, variable rate bonds in the form of structured credit products are going to benefit from rising rates as their coupons rise,” Hedges says.

Hedging risks

Analysing the picture further, as gilt yields/bond prices impact pension schemes on the asset and liability side, what should pension funds keep central to their thinking?

Hedges offers a succinct outline. “Pension funds face four risks that they don’t get rewarded for, three of them impact the liabilities: interest rates, inflation and longevity; the fourth is sponsor risk,” he says. “So, hedge the risks and then focus on investments to make returns to drive funding towards the long-term objective.”

Ghosh adds that investors should understand why they are buying bonds. “It is really important to get clarity of purpose for why fixed income assets are being held,” he says. “For example, highly hedged schemes may be happy to harvest spreads from potentially low return fixed income assets under a cash cow driven investment framework and not be unduly worried about rising government bond yields.”

Shaw notes there are niche classes within fixed income that still offer value – particularly short-term loans offering high yields. “By short term I mean six months to maybe 18 months and by high yield I mean several times what most traditional fixed income debt is paying.

“There are non-mainstream asset classes out there which can provide good yields and while traditionally these non-mainstream assets – such as P2P loans and private debt – have formed a very small proportion of assets, maybe the time has come to change that balance,” he adds.

Income stream

It is therefore an environment in which many subtle factors are at play, so Hedges believes that pension funds should stick to what they know. “Pension funds’ primary obligation is the payment of pensions to their beneficiaries. Fixed income will generate an income stream and notwithstanding a change in the bond’s value, the cash ow in terms of coupon payments remains unchanged, so changes in the interest environment don’t necessary change the cash that a fund is going to receive.”

Although Christopher Teschmacher, fund manager at LGIM, says that the traditional view of bonds is being challenged. “The efficacy of bonds as a safe-haven asset class in risk-off periods is now heavily compromised,” he says. “Indeed, recent months have shown an increasingly worrying pattern of bond yields rising on days when equities are falling, rather than the other way round. Holding duration in your portfolio hasn’t helped when you need it most.”

Shaw offers an alternative to fixed income for those concerned about yields. “It’s time to look at alternative assets,” he says. “But do spread your net widely and don’t invest too much in each alternative investment – try to get a basket of investments, and in that basked don’t stick to one provider but invest in a variety to reduce your risk profile.”

Ghosh urges caution here. “Alternatives to fixed income come with likely higher risk implications,” he says. “Pension funds need to evaluate if the purpose of fixed income is for driving high total returns or spread capture. If the ambition is high total return, then other options that allow greater upside opportunity, for example, equity or convertibles, may need to be entertained.”

“We hear a lot of talk about credit spreads compressing further and there may need to be a conversation in 12 to 18 months as to whether enough credit spread is now available to be harvested,” he adds. “This will be a challenging scenario as there are likely to be few options for decent returns at that point. One option could be to become temporarily defensive, for example, raising a little cash, and wait for the next buying opportunity.”

End of an orthodoxy?

The current debate around fixed income leads back to questioning the 60/40 orthodoxy – which, for many funds has held sway for some time. Is 60/40 therefore still relevant?

Shaw knows what should replace the 40% share of portfolios if fixed income is discarded. “Fixed income should potentially be replaced with floating rate or index-linked securities, plus a little more higher yield debt. Plus, probably some swaps to counteract the impact of moving interest rates on the calculation of the liabilities,” he says.

Teschmacher is focusing on inflation. “Intriguingly, we now believe that exposure to inflation-linked assets should be reduced or hedged. In fact, short exposure to inflation may benefit portfolios as a global economic shock would most likely see both equities and inflation falling, so this position could act to offset losses.”

Kwatra turns the situation on its head. “Perhaps there will be no such thing as ‘orthodox’ in this low-return higher risk world,” he says. “Every asset owner will re-appraise objectives in this climate and align portfolios towards their individual goals and risk appetites. For example, some may replace some of the fixed income with more equities or alternatives, others will increase the perceived illiquidity of fixed income portfolios.”

Although the 60/40 methodology is not a blanket approach to be used in all circumstances, as the founder of modern portfolio theory Harry Markowitz and his successors would no doubt highlight. “The 60/40 orthodoxy is a case-by-case consideration,” Ghosh says. “However, the question is more about what level of returns are needed and whether fixed income is being relied upon for high returns.”

And adjusting a portfolio is not a clear-cut business. “Any increased allocations to equity or convertibles would likely need to be o set by lower risk elsewhere in the portfolio if risk budgets are to be maintained. This is not straightforward,” Ghosh says. “One could also consider greater use of illiquid assets, such as private debt or infrastructure, to reduce reliance on traditional liquid fixed income.”

Considering a wider range of assets gets Teschmacher’s vote. “Our go-to response to any portfolio challenge is to increase diversification, looking for more and varied return streams from the available investment universe to help smooth portfolio returns,” he says. “Where we do continue to hold government bonds, we want to seek higher yields from steeper yield curves, as we believe these yield curves have some propensity to compress if the world faces a new economic downturn. Examples could include Australian and Chinese bond markets.”

For Hedges, it all comes down to the specifics of the fund. “It will vary from fund to fund,” he says. “As rates rise fixed income may become more attractive; many fund managers may have been short duration so they can capture this relatively painlessly. In addition, we have seen pension funds embrace private credit and debt funds as an alternative means of generating cash ow and higher returns.

“Open pension funds are also likely to look to other forms of cash flow investments and invest in core infrastructure and operational renewable energy activity as a way of enhancing and diversifying their cash flow generation.”

Risk appetite

The central point, and one that is difficult to escape, is that fixed income assets perform an important function for institutional investors, underpinning many portfolios. “Pension funds still need investments which deliver predictable cash-flows to meet liabilities,” Kwatra says.

“To avoid chasing excessive risk in this low return world there needs to be a clear risk appetite framework to decide how much investment risk can be tolerated and where is it most efficient to take this,” he adds. “A range of strategies across public and private investments is required.”

And pension fund allocation is very much a mix of liability matching assets and return seeking assets. “Fixed income straddles both portfolios,” Hedges says, “but the rationale for holding them in the matching assets portfolio is risk management not investment return.”

The needs of pension funds differ, depending whether they are closed, open, how well funded they are and where they are in their lifecycle. “So, the need for fixed income will be different for each scheme,” Hedges says. “But there will always be a need for cash flow – and fixed income will play a role in this.” As pension funds are long-term investors, liabilities are long dated and they are only going to materialise slowly. “So, pension funds don’t panic, they are not hedge funds or day traders they invest for the long term,” Hedges says.

“Strategic asset allocations are long term, and while funds may take advantage of tactical market opportunities ultimately taking such activity is incremental to overall return which is predicated on a long-term investment view,” Hedges adds. Therefore, on the future fixed income outlook within pensions portfolios, Hedges indicates it is a simple case of not being taken in by the current Buffett driven headlines. “There will still be a role for fixed income: pension funds need to hedge their risks and need to generate cash ow to meet pension liabilities.”

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