Fixed income

Roundtable

Fixed income: Interesting times

These are interesting times for bond investors. To find out how institutional investors are approaching this market’s many challenges, we brought asset owners together with a bond manager, a professional trustee and a consultant for an online discussion.

May 2021

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These are interesting times for bond investors. Indeed, inflationary pressures, low interest rates and rising default fears mean there are many obstacles for investors to consider when building a fixed income portfolio.

To find out how institutional investors are approaching this market’s many challenges, we brought asset owners together with a bond manager, a professional trustee and a consultant for an online discussion.

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Participants

Jim Cielinski, Global Head of Fixed Income Janus Henderson

Jim Cielinski oversees all of Janus Henderson’s global fixed income products and teams as well as leasing corporate credit. He joined from Columbia Threadneedle in 2017, where he was global head of fixed income for seven years. Before that he spent 12 years at Goldman Sachs Asset Management as managing director and head of credit. He has also been the head of fixed income for Utah Retirement Systems, assistant manager of taxable fixed income for Brown Brothers Harriman & Co and an equity portfolio manager for First Security Investment Management.

Kilian Thevissen, Investment Manager, National Grid UK Pension Scheme

Since 2016, Kilian Thevissen has been responsible for National Grid’s UK pension scheme’s portfolio construction and manager selection. He also monitors its asset allocation sleeves, which include LDI, fixed income, equities, alternatives and private market investments. Before joining the scheme, he spent seven years at Philips’ pension scheme in the Netherlands, holding various roles within its investment team focusing on analytics and risk management as well as manager selection and monitoring.

Alan Pickering, President BESTrustees

Not only is Alan Pickering president of BESTrustees but he is also a trustee of the retirement plan for plumbers and mechanical engineers as well as for workplace scheme The People’s Pension. His industry experience is vast having served as a non-executive director of The Pensions Regulator and a member of the Occupational Pensions Board. Pickering is also a former chair of the body that is now known as the Pensions and Lifetime Savings Association (PLSA) and held the same position at the European Federation for Retirement Provision. In 2002, he wrote the government-sponsored report A Simpler Way to Better Pensions.

Ian MacRae, Pensions Investment Manager, JaguarLandRover

Ian MacRae manages JaguarLandRover’s defined benefit (DB) scheme’s asset and liability risks together with its funding arrangements. He also chairs the management committee of the car-maker’s defined contribution (DC) pension scheme. For nine years MacRae has worked within the treasury function to improve the stability and predictability of the DB scheme’s funding. Before joining JaguarLandRover he was an investment consultant at Mercer in Edinburgh.

Peter Martin, Investment Officer, Medical Defence Union

Prior to becoming the investment officer of the UK’s largest medical defence unions, Peter Martin was head of manager research at pension consultancy JLT Employee Benefits. Martin sits on the Society of Pension Professionals’ investment committee and represents the organisation in the Debt Management Office’s quarterly consultation.

Carl Hitchman, Chief Investment Officer, UK investment consulting, Buck

Carl Hitchman is responsible for Buck’s investment philosophy and approach to advising on managers and markets. This has included strategic asset allocation, asset/ liability modelling, liability-driven investment, cash flow-driven investment, derivatives and asset transfers. His experience extends to asset administration, fiduciary manager over-sight and investment governance. He has spent more than 35 years in the retirement industry. He started his career as a pensions actuary before becoming an investment consultant in 1993.

The discussion

portfolio institutional: How are institutional investors using bonds these days?

Kilian Thevissen: National Grid’s pension scheme is relatively mature, so our fixed income allocations are primarily investment grade. While there are some pockets where we aim to generate alpha over appropriate benchmarks, the bulk of our investment-grade fixed income exposure is in long-term buy-and-maintain portfolios or private investments, where we look to harvest an illiquidity premium over public market equivalent bonds.

Ian MacRae: We have a strategy to create a secure and reliable income stream to match the benefit outgoing for our pensioners. Our schemes are relatively immature, so that makes up around 40% of our assets. The balance is spilt between our liability-driven investing (LDI) and growth portfolios.

Within LDI we look to hedge interest rate and inflation risks for non-pensioner liabilities, while the growth portfolio uses bonds to diversify and access different risk premiums.

Alan Pickering: LDI is at the heart of most of my defined benefit (DB) schemes. We are on a journey plan, which for three of my four schemes will come to an end during this decade. In the run up to buy-in/buyout we are using bonds to provide diversification, risk management and, to some extent, create a buy-in/buy-out-ready portfolio.

For instance, we might use short duration bonds which could be easily liquidated when the time comes for buy-in/buyout. As we move towards low dependency on the sponsoring employers, we are trying to tap into different aspects of the fixed income market. A, to provide a return slightly north of bonds, and b, to prepare for buy-in/buyout.

PI: How does it differ in your defined contribution (DC) schemes?

Pickering: The jury is out as to whether it should be growth all the way during the accumulation phase, or if there should be a bond element within the default funds. There is a lot of thought being given to diversification and multi-asset at all points in the accumulation phase. If it is used, I favour dynamic management of fixed income portfolios than a passive approach.

As we come to the consolidation and decumulation phases, there will be a role for fixed income. In the self-select element within a DC scheme, again I would support a dynamic rather than passive option.

PI: What do your clients want from fixed income these days, Jim?

Jim Cielinski: I view it as a bit of a dichotomy. A lot of our clients are seeking income, but there is a dearth of income even with the rate and yield increases we have seen. They want income, but income with risk control, income with a defined drawdown. Equally, there is a focus from our clients, particularly away from DB, on shorter duration products, on limiting interest rate risk – with rates last year moving to extraordinarily low levels.

So, there is a desire to have many types of credit risk and the ability to rotate across sectors. We have seen a shift. It is more conservative on the rate risk side. We still have clients who want longer duration to hedge liabilities, but more often than not they want that agnostic approach.

Carl Hitchman: Many of our clients are focused on cash cow. In cash flow-driven investing (CDI) the starting point is: do you have enough money to solely invest in different types of credit and gilts. If not, how much do you need to hold in growth assets to fill the gap?

In holding growth assets, the portfolio is typically structured on the assumption that they will be held long term. So, you are allocating them against your cash flows 15 to 20 years down the line. Essentially, you are letting those growth assets grow. You are not going to become a forced seller but what you can do is exploit the upside volatility if those assets deliver stronger returns than anticipated.

Key to all of this is that as pension funds mature, fixed income is going to be a much bigger portfolio component. This in an area we are focusing on.

Peter Martin: With bonds it is a question of being open minded in looking for opportunities without taking excessive risks. It is not necessarily about maximising return but trying to get an appropriate return from the combination of assets available.

Going forward, we must be cognisant of the environment we are in – where rates are low and credit spreads are tight. Quality is safe and stable and that is appropriate for some, but it is a mediocre return for the foreseeable future. If that is deemed not sufficient, you have to move up the risk profile, so there is no free lunch. We are in a different environment from 10 or 20 years ago in that the ‘easy money’ has gone.

PI: What impact has the pandemic had on fixed income portfolios?

Cielinski: Aside from rates plummeting to record lows and bonds becoming overvalued on most metrics, what has changed is the regime in which we live. This crisis passed the baton from monetary to fiscal policy, which created fears of a notion that you can borrow unlimited amounts and it stays affordable. So, there has been a shift in how the policy reaction will work.

When we look back, this will be the moment when our framework had to adjust to the outlook for inflation, the outlook for deficit spending and the outlook for politics, in that we could see people elected on the promise of more spending.

Pickering: Quantitative easing (QE) and modern monetary theory have promoted us to rip-up everything we learnt from textbooks in our youth. It has created uncertainty and an air of challenge. This is a good thing in that you cannot take anything for granted. Who would have guessed that we would end up having big government in the UK and US?

At a more micro level, the pandemic has forced us to focus on quality. We need to concentrate on the covenant of those on the other side of the fixed income products to a greater extent than we did before. So, we have uncertainty at a macro level and uncertainty at a micro level, which selfishly makes my job so enjoyable.

There is a desire to have many types of credit risk and the ability to rotate across sectors.


Jim Cielinski, Janus Henderson
PI: Ian, has the pandemic forced you to focus on quality?

MacRae: Our investment strategy is based on moving assets from growth/LDI to our CDI portfolio as our liabilities mature. That gives us opportunities over time to take advantage of relative pricing differences between cash from the LDI portfolio or growth assets compared with bonds and other assets purchased for our CDI portfolio.

The turbulence we saw in 2020 helped us transition more of our liabilities into our CDI portfolio at attractive prices relative to the assets we sold. The quality of the covenant of the bonds we buy is critical, especially as, ideally, we would hold them in our CDI portfolio to maturity. We buy bonds that we are con dent will retain their quality and income. That security comes in many forms, whether it is the covenant of the issuer or the collateralisation.

Thevissen: In February and March 2020 we saw a significant spread widening, which was an interesting time to consider an increase of exposures to long term investment-grade credit. It was an opportune time, but as usual we took a careful approach, always considering potential downside risks. Before you invest with a buy-and-hold to maturity objective it is essential to have a profound long-term view of a company, for example a clear idea of how the company is aligning its strategy with the ongoing energy transition. If you are investing for 10 years plus you have to get it right in the first place, otherwise you may be forced to amend your exposure later on – likely at a wider spread and incurring transaction costs – which is not ideal for a buy-and-maintain portfolio.

PI: Inflationary fears have been rising. Do you expect that to continue, Jim?

Cielinski: I do not see it dissipating, but markets have priced in a lot of inflation. In most developed markets we are looking at 2.5%, although the US’ longer term inflation expectations are slightly higher.

It is difficult, if you look at the last 30 or 40 years, to get meaningfully above that. The inflation expectations have been behind the rate increases we have seen this year, although I am having a hard time expecting that to continue from those levels.

That said, inflation will be higher in the next few months. Quoted inflation is done on a year-on-year basis, so we are moving into a period where we have pandemic-related deflation. Combine that with commodity prices and we are likely to see in inflation numbers that look a lot worse than they have been. That does not lead to another round of inflation fears. I am more worried about the level of real rates and if global growth is strong enough to drive them higher.

Martin: It is always right to consider how exposed you are to unexpected inflation, either positive or negative, and have a scenario plan to see if your portfolio could withstand it or not. There is a pent-up demand for inflation protection from pension funds in the UK and that is not going away. The price of UK inflation will remain expensive given the demand and with clarification of the CPI changes, which will drive more trading because the uncertainty has gone.

It is, on a relative value basis, whether you are prepared to pay for inflation-linked gilts or areas that provide inflation within the assets, such as corporate linkers or housing associations. With my trustee hat on it is about de-risking. If you can take the risk o the table it is a price worth playing, but you can still play that journey sensibly.

Hitchman: The risk of inflation has increased. The extent of the fiscal stimulus pushes us into a different space in terms of: is a policy response going to help us through the crisis or stoke inflation? No one knows, is the frank answer.

Over the past 20 to 30 years there have been all sorts of reasons why inflation has been coming down and has been sticky. For example, there has been lots of discussion about the impact of demographic changes and whether the underlying dynamics are starting to change.

The market in the first quarter gave a taste of what could happen. Rates were rising and trigger points were being hit in some leveraged LDI portfolios with cash calls made to fund these. Over the past 10 years as rates have been coming down, leveraged LDI has not only generated strong returns, but thrown o a lot of cash that has paid pensions and rebalanced portfolios.

The challenge is that if it starts going the other way and there are cash calls, you have to fund that from somewhere, assuming that you want to keep your hedging. Does that then eat into the growth assets you rely on to fund your de cits?

It is crucial when setting strategies in this environment to factor in the increasing risk of rising rates and have liquidity and collateral ladders in place that will allow you to meet these cash calls without jeopardising the long-term funding of the scheme. From that perspective, considerations of inflation are key given where we are and the fiscal response that has come our way.

Thevissen: Inflation is a risk that we hedge similar to how we hedge rate risk. When it comes to liquidity/collateral management, we did not get into a difficult situation in the past few months, but it is a space that we watch.

MacRae: We consider inflation and rates from the view of do we want that risk? We are heavily hedged against those risks and that has been positive while rates have been dropping. We need to look at where rates could go and the risk of higher rates.

On the inflation side, the cost of hedging in the UK is high, especially post 2030. We use real assets to access inflation protection in our CDI portfolio, which we overlay with direct inflation hedging. We consider the cost of hedging that risk against the reduction in volatility we could achieve, so there is a regular re-evaluation of the costs of hedging versus its benefits.

In summary, if you cannot absorb the risk, you need to hedge it. If you can take some risk, and it is expected to generate returns, then you can move away from a naturally hedged position to some extent.

Pickering: There has been an unholy alliance between the sophisticates and the not-so-sophisticates who say there is a limit to what price you want to pay for protection against inflation. Today, the argument that the approach should be scheme specific holds good, and if the employer and trustee want to batten down all risks, they may be willing to pay a higher price for battening down the inflation risk.

In DC land, members might be sensible in battening down inflation risk if their pension is the only income they have in retirement. If they have other sources, they maybe more relaxed about battening down every risk. As far as volatility is concerned, it will increase as large amounts of money exploit opportunities or react to uncertainty.

As a long-term investor, volatility can be your friend, but if you have a short-term horizon, as many defined benefit schemes have, then it could be your enemy.

Quantitative easing and modern monetary theory have prompted us to rip-up everything we learnt from textbooks in our youth.

Alan Pickering, BESTrustees
PI: How will fiscal and monetary policy effect the price of bonds and risk assets going forward?

Cielinski: Monetary policy’s affect is now limited to the forward path of short-term rates because central banks can stay on hold forever, so it is up to the fiscal side to drive bond markets.

At some point you start to price in rate hikes, but that is a long way off. For bond market drivers in the near term, I am looking at fiscal policy and if central banks keep testing the limits of how much they can borrow and spend before it pushes bond markets too high. When you do that it can be self-correcting as at some point bond yields will go too high and impact other risk assets.

Keep in mind that it is not just about spending today but the fiscal cliff that gets created a year from now. One-off big expenditures become detractors. Everything feels great right now, but in a year it could be a different story. This spells more uncertainty and volatility on inflation, rates and policy.

PI: How do schemes select a bond fund manager?

Pickering: As a trustee, I rely on the intermediary. I need a consultant in whom I have confidence that they understand the market and what I require from that market. One of the advantages of being a professional trustee is that I do not necessarily need a household name, provided that the consultant can convince me that the fixed income manager is not only good but is appropriate.

Hitchman: Credit selection skills are fundamental to everything. In credit, active management is the way to go because there is a lot of value that could be added from a proper credit assessment to mitigate the default risk. Credit spreads have tightened, and asset prices generally have been pushed up because of QE, so the margins have become thinner. That is an environment where a good credit manager can make a huge difference in delivering returns.

Above and beyond that, a lot depends to some degree on the nature of the credit. In the private credit market, you need people with experience of structuring – and sometimes restructuring – as well as the contacts to originate deals. These assets are illiquid, so what access do they have to the market and how quickly can they execute?

Trustees want to have confidence in a manager, but they also want to monitor that manager. If that manager does not have the disclosure policy or the communication skills to articulate what are complex assets, it becomes difficult to build confidence in terms of monitoring the manager. So, the ability to communicate around the asset class, such as performance, is a key component.

Martin: You need people who can deal in this asset class because bonds are a specialism. A lot of the fundamentals have not changed, but there are different additional questions that I would ask now. One is around how they handled the pandemic. It is also important to consider what a bond manager is doing on responsible investing. Given the current environment, delve beyond ESG integration which was perhaps sufficient three or four years ago. The story has moved on.

I am not interested in the apple pie-type statements, but what can they measure? What impact can they show? How are they doing things differently with TCFD reporting coming our way? How are they aligned with the Paris Accord? The transition pathway? It is an important topic and you need to find a partner that can help you on this journey. In looking for a new bond manager it is about how they manage that process, what lessons they have learnt and how it makes them stronger going forward.

MacRae: In our CDI portfolio, we need to think about a bond manager’s analytical skills as we look to hold credits ideally until they mature. It is a huge universe and we are not only looking at investment grade, so market access is critical. We need managers who understand the environment in which they are investing. We use a fiduciary to select managers to meet our goals, which means we need to be careful about the philosophy we expect our managers to follow and that this is clearly communicated.

Thevissen: Do not just provide 10 slides on ESG, show me evidence of how it has made an impact on the portfolio. That is the key challenge we ask our candidates to solve these days. The world has moved on, we have all progressed and are more ambitious than ever to integrate relevant ESG factors into the investment processes that drive our portfolios.

A lot of managers are struggling with this, and those who have, are still facing challenges to evidence it in a structured and consistent way. Reporting on high level ESG metrics is relevant, but is only the tip of the ice-berg in terms of what you want to see from your managers.

PI: So, how do you want ESG integrated into your portfolios?

Thevissen: Climate change is a key systematic risk that needs to be addressed. We have a strategy which will see us divest from coal- related assets by 2022. Beyond this, we are engaging with our managers across the various asset classes to integrate relevant ESG factors into their ongoing investment processes.

While with regards to coal we chose divestment, we generally prefer an engagement route that results in firms changing their long-term strategy to address climate change risks and opportunities. However, that ambition will not succeed with every investment we hold, so divestments might happen over time.

MacRae: Reporting is currently patchy and, in my view, easy to misinterpret. It is also backward looking, so the concept of making decisions based on this reporting does not make sense.

The idea of whether to divest or engage based on reporting is important. As the reporting does not reflect how companies are developing their future strategy, we generally prefer engagement. We want to get to a position where our managers make sensible decisions based on the fundamental comparison of the price and the resilience of our bonds incorporating the ESG considerations.

PI: Alan, most of your DB schemes are on the path to their endgame. Is ESG important if you are going to exit in this decade?

Pickering: ESG is important whether I am in DB land or DC land. When it was called ethical investment or socially responsible investment, I was a sceptic. I am, however, a fan of ESG, provided we give equal weight to each of those initials.

I see a world soon where there will not be ESG investors and non-ESG investors. ESG should be embodied in everything we do. What worries me as a trustee is that I am on the receiving end of a bureaucratic paper chase. From all quarters, I am being asked to comply with this target and that target by a particular date. It is so overwhelming that if we are not careful, ESG will become a box ticking a air rather than a brain box consideration.

PI: Jim, are you seeing rising demand from asset owners to factor ESG into their fixed income portfolios?

Cielinski: We do not have a conversation with a client without ESG coming up. There are different styles and some clients want a different approach. Like active management, this is a sector where there are different ways to do it.

That said, they want to see an impact on portfolios. The greenwashing element has come to the fore and people want to know that you are practicing something that will make a difference. Engagement is usually the way to make that happen.

We can do exclusion lists, positive impact, best-in-class screening, but one of our principles is to choose companies that might be poor at ESG, but if we engage with them and make them better, that is a success. But reporting is backward looking, so it might penalise the client who is trying to do that.

We are at the point where we have integrated ESG into our analysis, but as an industry we need to do a better job of defining what it means, how it can be used and evidence the impact we are having on portfolios. It is evolving quickly. We are trying to be partners and good strategic thinkers alongside our clients to make this work across their portfolios.

Reporting on high level ESG metrics is relevant, but is only the tip of the iceberg in terms of what you want to see from your managers.


Kilian Thevissen, National Grid UK Pension Scheme
PI: How easy is it to engage with companies as a bondholder?

Cielinski: Surprisingly easy. We are not voting stakeholders in the way that equity holders are, but these companies are frequently accessing debt markets. If they can sell their bond at a quarter of a percentage point lower if they did not have these ESG risks, they start to listen. Aside from that, they know that with the trends that are unfolding they have an obligation to deliver on more than one front.

As a stakeholder on the bonds side, we say we will lend to you at a lower rate if you can do this. They are receptive to hearing that.

PI: How would you describe the quality of ESG reporting?

Hitchman: It is a changing landscape. It is not just about looking backwards. It is a journey in terms of the reporting trustees receive from their advisers and managers to evidence the actions they are taking and the value they are adding.

Fundamentally, if you want to see the importance of ESG look around the world to see what is happening. These are important issues that pose real world risks to all investments, so it is imperative that these are looked at. ESG is one of many risks and it is important to judge this as part of the assessment of a company’s credit risk.

Martin: Everyone is on a journey. The infrastructure needs to be put in place to provide the reporting needed. There are issues between loans, private equity sponsors, liquidity and what is available, but just because it is hard does not stop you from doing what you can and then engage to improve it over time. This is a journey. I do not expect perfection today, but we have to start somewhere. It might be the easier bits that we start with, but we have to take that forward.

It is not a question of a ‘nice to have’. The world has changed and there are a series of increasing demands on trustees to report on these matters. Fixed income investors can play an important role in discussions with companies. In respect of equities, you are generally buying ‘second hand’, you are not providing capital, IPOs aside.

For a new issuance or companies which regularly tap the debt market, you can say as a bond investor that “for me to lend you money you must provide the following criteria or improve your reporting on them”. If they cannot produce that reporting, we may not lend them the money or perhaps charge more for it.

In some respects, bond investors can arguably have more influence than equity owners on these aspects. For pension schemes, which have a lot of their money held in contractual fixed income assets, engagement will become more important. However, transparency will have to improve greatly.

PI: What do you expect to see in the fixed income markets in the coming year?

Cielinski: Rates could rise further, but from these levels they will be contained. That said, I would focus on growth assets, credit risk, mortgage risk, increasingly look at things secured by real assets which should bene t from the recovery. You are still not paid enough for taking a lot of interest rate risk.

So, I would favour shorter maturity bonds. Much of the rate rise we expected is prob- ably behind us now. Bond yields are now at fair value, if not a little bit above. They have priced in higher inflation, so a lot of the pain we have seen in the past few months will not persist.

Pickering: Fixed income will be an interesting place for young investment managers to work. In the past it was regarded as a boring, poor relation of the equity market. Now there are so many ways we want to tap the fixed income markets that there is opportunity for creativity to make it a win-win for borrower and lender.

Hitchman: There are some interesting opportunities, but with the fiscal medicines that have been provided in the past 12 months, when things start reverting to the new normal, whatever that looks like, default risk will potentially rise. Whilst there are attractive opportunities, having a good credit manager to mitigate those risks will be key to generating returns from current pricing, which we believe has been inflated by QE. There is a real risk of inflation increasing and the impact that could have over the medium term.

MacRae: Whilst taking opportunities to capture attractive pricing will improve overall returns, ultimately the overall strategy trumps most things. Systematically securing the income we need over time, and measuring liabilities based on this income yield, transforms funding discussions with the sponsor.

Taking advantage of pricing opportunities that arise to capture the quality of income we need, either relative to cash or growth assets values, improves the funding position. But ultimately, you need to have a clear funding and investment strategy to drive funding outcomes. Bond pricing is not a secondary issue by any means, but it may not be the first consideration for the pension scheme investor.

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