Cover story – Fixed income

medium-term returns available from fixed income and invaria- bly 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 cashflow 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-main- stream 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

20 | portfolio institutional | April 2021 | issue 102

the bond’s value, the cashflow 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 urgers 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 con- vertibles, 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 ques- tioning 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 lit- tle more higher yield debt. Plus, probably some swaps to coun- teract 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.”

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