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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 liabil- ities,” 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 portfo- lios 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 appe- tites. For example, some may replace some of the fixed income with more equities or alternatives, others will increase the per- ceived 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 the- ory Harry Markowitz and his successors would no doubt high- light. “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 offset 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 cashflow 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 cashflow 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 cashflows to meet lia- bilities,” 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 match- ing 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 cashflow to meet pension liabilities.”
May 2021 portfolio institutional roundtable: Fixed income 21
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