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Let’s face it: Interest rates aren’t skyrocketing any time soon.
Last month, the European Central Bank (ECB) lowered its nominal rate to the lowest point in history, a move meant to fall in line with other major influencing economies.
Most sophisticated investors have already discarded government- and sovereign-backed debt, and are struggling to keep faith with poorly performing investment-grade fixed income.
In fact, November’s Bank of America Merrill Lynch fund manager survey found investors had allocated the lowest level of assets to fixed income since the report began. For pension funds that have to keep a fairly substantial allocation to fixed income due to its liability-matching properties, the current monetary policy could be used to their advantage.
The current artificially low interest rates have produced historically low default rates in the corporate bond sector. At the end of October, global high-yield default rates had fallen to 2.8% from 3.2% a year ago, figures from rating agency Moody’s show. In the US, default rates fell to 2.5% from 3.6% last year, and in Europe, a 3.2% rate was down a touch from 3.3% at the same point in 2012. This demonstrates how the term “risky” does not have the same dramatic meaning as five years ago—but investors are still rewarded for holding the lower-rated debt.
“Credit might not be the saviour of fixed income,” says Alex Gracian, CIO of the London Pensions Fund Authority (LPFA), “but it could be a centurion in its army.”
Indeed, the sector may not have achieved double-digit returns in 2013, but it has ground out an uplift of two percentage points or more over higher-quality fixed income, which just about made it over the line.
Danish national pension ATP has been reaping the benefits of these more assured corporates in its risk-factor approach to investing. “Absolute spreads are back to where they were in 2007,” says Anders Hjælmsø Svennesen, co-CIO of ATP. “There is very little available on the risk-free side of things, and we hedge out all of the interest rate risk so we are just left with the credit risk premia.”
But is the low-default environment sustainable—and will investors continue to be rewarded? At Deutsche Bank, leading bond strategist Jim Reid predicts low defaults will hang around—or be forced by central bank policy to stay—for a couple more years, but it does not automatically follow that returns will be sustained if more people crowd into the trade.
“Credit can still help deliver the outcomes we need if yields drift up,” says Mark Mansley, CIO of the Active Pension Fund at the UK’s Environment Agency. “We are looking quite closely at credit and are monitoring the narrowing of spreads. I don’t believe we are in a bubble yet, but the upside for spreads is getting less.”
Some think blue-chip corporate securities—the names usually bought by shorter-term investors—are already fully valued, and thus several investors are looking more broadly. “It’s difficult to price in rates over and above what has already been priced in,” says Ian McKinlay, investment director at the Aviva Staff Pension Scheme. “The only way to make money is if rates rise higher and faster than the market thinks. We’re looking at the forward curve and thinking it looks OK—if you don’t think that, you’re fighting the central banks. Who would do that? They are conducting the largest financial experiment in history.”
Better to be diversified, then? “We have a barbell approach: On the one side, we have gilts and conventional fixed income, and then we have alternative debt portfolio, which includes aircraft leasing, shipping finance, and ground rents,” says Gracian at the LPFA. “We have to capture the illiquidity premium. There are various options, including moving around the capital structure and looking at private and illiquid debt.”
Illiquid debt has captured the imagination of many a bold investor, but some—including Leandros Kalisperas, credit manager at the Universities Superannuation Scheme (USS)—fear the low-hanging fruit has gone and funds will have to work harder for returns.
Bank deleveraging may hold promise, says Gracian, who is waiting for the ECB’s next round of stress tests in one year’s time. McKinlay warns, however, that only the most sophisticated—or those with very good advice—should get involved in this sector, and they should all have an exit strategy before going in.
“No asset class is wonderful at the moment, so you just have to get stuck in and get the job done,” he says, “then you might have to change the rules a little...”
The rules he refers to have already been changed by equity investors. Now it is time to turn attention to fixed income. “There has been a lot of noise about smart beta, about non-market cap-weighted portfolios—but only in terms of equities, as far as I can tell, not for fixed income,” he says. “Fixed income could benefit from this diversity. At the moment, investors are often lending money to the most heavily indebted companies. Bonds have even more downside risk, so there are certainly benefits to diversification.”
Gracian sees the idea being developed, too. “I would like to see more innovation in alternative indexing outside equities—and fixed income is the most tractable. Obviously, investors have to be selective about the plays they take. Financials and industrials are good, not just looking across all high yield and investment grade, but relative value plays.”
USS is already climbing the thought curve, having brought on an investment bank to create such an index in its emerging markets portfolio, which Kalisperas believes is a good fit. “We only want exposure to certain countries, so our benchmark is not market-cap weighted,” he says. “In fixed income, there is a whole universe of factors to consider and build alternative indices—there has been a bit of talk but not much action.”
This could be the next challenge for fixed-income managers who want to woo back investors: clever benchmarking that fits with institutional investors’ needs.
“People are realising that generic fixed income has had somewhat mixed performance in matching liabilities, and are becoming more sophisticated in this aspect of the portfolio, running more explicit liability-hedging programmes. This means the bond portfolio is being freed up to become more focused on return-seeking and open up to a broader set of ideas,” says the Environment Agency’s Mansley.
“Pension funds have to look at fixed income in the same ‘breath’ as equities; we have to be more open to the different options—but not get carried away.”
The most sophisticated investors are interested, so it is up to providers to take the next step. Maybe this will be a means to avoid bubbles for good.