Investing in bonds may not offer the thrills and spills of equities, but the fixed income market has witnessed big changes over the past few years. Government bond issuance has gradually diminished and many corporations have stepped up their bond programmes to mop up unsatisfied investor demand for quality fixed income instruments.
Though pension funds regard equities as vital for achieving strong growth over the longer term, the recent rout in world stock markets has reminded many investors that there is real value in the stability offered by bonds.
So the task of finding a benchmark to suit a fixed income portfolio has become less straightforward for European pension funds. Index providers now offer a wide range of fixed-income indices against which funds can measure the performance of their asset managers, but which one should they choose?
Hasse Nilsson, chairman of consultant Alcifor Advisory Associates in Denmark, says Danish pension funds generally link up with the fixed income indices offered by US institutions JP Morgan or Salomon Smith Barney for the international part of their portfolios. JPMorgan offers a range of indices that cover emerging markets, government and corporate bonds.
Morgan Stanley also offers fixed income indices that cover bonds carrying lower credit ratings. Nilsson says the Morgan Stanley indices are used extensively by the majority of institutions.
But Danish pension funds also use smaller classes of bonds that are issued domestically – this includes mortgage bonds. When investing in this sector, the funds have no choice but to use the indices for these securities produced by the respective stock markets.
Olav Rune Overland of Wassum Investment Consulting in Oslo says that, for international bond investment, Norwegian pension funds typically choose a global index like the Salomon Smith Barney Government Bond Index.
“Very few Norwegian-based funds take credit risk in their international fixed income investment,” he says. “This is due to the capital weighting regulations in Norway. Investments are weighted according to the BIS regulations, meaning that a corporate bond requires as much capital as equity investments,” he adds.
Few investors – in Norway at least – view corporate bonds as a separate asset class, says Overland.
But who in the investment chain actually chooses which index to use? Consultant Arthur Huits of Buck Heissmann in the Netherlands says the choice of fixed income benchmark is often initiated by the asset manager, rather than the pension fund. “They have standard benchmarks they use,” he says. “For Europe, most pension funds follow European benchmarks – and there’s not a lot of choice.”
Among euro bond indices, iBoxx, owned by a consortium including Deutsche Börse, publishes the iBoxx euro family as well as sterling gilt indices. Sterling corporates and others will be launched in the near future. The indices are grouped into four distinct sub-index families.
These are sovereign and sub-sovereign, which replicate the market for bonds issued by national governments or regional governments, government-like institutions and organisations. There is a separate sub-group of indices for bonds secured by collateral and the fourth index sub-group is composed of corporate bonds.
Goldman Sachs produces a family of global credit indices, which includes Euro-denominated bond benchmarks. The index family includes the US$ Investment Grade Index, and indices for Euro Investment Grade, European High Yield and US$ High Yield. It believes that what sets its indices apart from the competition is the liquidity indices within each category.
The liquidity, or Top, indices run alongside each of these broad market capitalisation indices. They consist of bonds, in each category, which are chosen to maximise liquidity and keep a good representation of the broad market.
Other providers of European bond indices include Merrill Lynch, Lehman Brothers, MSCI, Reuters, UBSW, Salomon Smith Barney, Barclays, Bloomberg and Datastream.
Providers of the fixed income indices on offer are quick to point out the differences between these competing yardsticks. But Overland of Wassum says the choice between the individual providers is not crucial.
“We see very small differences in the indexes used. Norwegian-based investor use globally recognised index providers. The only difference is that – due to the positive interest differential – Norwegian investors want indexes hedged into Norwegian kroner.”
With many governments now issuing less debt and interest rates at a low level globally, there is a growing demand for corporate bonds. Institutional investors are attracted in particular by the high yield premium these relatively secure investments can offer.
But the market for credits in Europe is still not very big, says Huits. In general, pension funds choosing this type of non-sovereign security have to opt for credit funds. But, even here, corporate bonds do not play a large role. Many fixed income funds contain around 10% corporate bonds, says Huits.
Although most pension fund fixed income mandates are firmly associated with a particular benchmark, some pension funds believe a more flexible approach is necessary. An investment manager of one large UK pension fund said he was not keen on setting a specific benchmark.
“If you give an investment manager a benchmark, he will use it as an excuse,” he says. “We like to give the manager the flexibility to use his initiative and the opportunity to add value,” he explains.
Alcifor’s Nilsson agrees that some pension funds are choosing to go down the route of avoiding setting very specific benchmarks for their fixed income portfolios. “But they investment_managers usually end up measuring themselves against an appropriate benchmark anyway, or against peer group performance.”
“Benchmarking is becoming increasingly under pressure, because the benchmarks are being changed so much recently,” he says. This has led to a view that the benchmarks are unreliable.
Growing internationalism is the main factor behind these multiple shifts in fixed income benchmarks. Nilsson points out that a few years ago, only 2% of a Danish pension fund would be invested in foreign bonds, but now the proportion has soared to 60, 70 or even 80%. This goes for equities as well.
Innovations in the bond markets have also kept the sands shifting under fixed income benchmarks. Straightforward emerging market bonds, for example, are becoming increasingly anachronistic, he says. “In terms of the benchmark, this blurs the picture,” says Nilson.
But though there may be an argument for allowing asset managers to take a more pragmatic approach to a fixed income mandate, other consultants believe it is difficult under current pension fund rules for many of them to avoid setting a concrete benchmark for fixed income investment. “The pension fund board is responsible in all situations … they can’t simply say to investment_managers go and do whatever you want,” says Huits. “The asset manager must be judged relative to the performance of a benchmark.”
Overland of Wassum agrees that pension funds should use specific benchmarks for fixed income mandates as for any other mandates. “Due to the capital weighting regulations we normally see pension funds set tight investment guidelines allowing duration bets but few investments into lower credit categories,” he says.
One of the key issues for pension funds investing in fixed income at the moment is Japan, he says. “The fact is that most of these (international) benchmarks place 30% of capital into the Japanese debt market, and I’m not sure that’s appropriate,” he says.