Fixed income – Cover story

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 portfolios.”

perceived illiquidity of fixed income

Although the 60/40 methodology is not a blanket approach to be used in all circumstances, as the founder of modern portfo- lio theory Harry Markowitz and his successors would no doubt highlight. “The 60/40 orthodoxy is a case-by-case considera- tion,” 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 portfo- lio returns,” he says. “Where we do continue to hold govern- ment 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 gener- ating cashflow and higher returns.

“Open pension funds are also likely to look to other forms of cashflow 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 institu- tional 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.”

For a pension fund, much of the holdings of gilts and linkers aren’t bought for their investment returns, they are primarily about

managing the liability risks. Mark Hedges, Nationwide Pension Fund

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 manage- ment 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 cashflow – 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, pen- sion 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 tak- ing such activity is incremental to overall return which is pred- icated 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.”

Issue 102 | April 2021 | portfolio institutional | 21

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