Bond Strategy: Time to reallocate?
Nimisha Srivastava and Harald Eggerstedt call for a rethink of fixed-income investment in the face of the ECB’s asset purchase and QE programmes
At a glance
• Despite the ECB’s efforts it is possible that monetary policy will introduce structural distortions into the corporate bond market.
• Underfunded pension funds employing a mark-to-market approach for their pension liabilities are likely to see funding gaps widen and liability hedge ratios decline.
• This is a good time to diversify into other areas of credit.
• Investors should rethink their approach to bond investing.
The rate cuts and quantitative easing policy of the European Central Bank (ECB) have pushed low yields on euro-zone bonds even lower. Holders of cash are being penalised and over a third of government bonds are trading at negative yields.
In March 2016, the ECB announced further measures to stimulate the flow of credit to the corporate sector, including an extension of its bond buying-programme to corporate bonds. In anticipation of this activity, investment grade credit spreads have compressed further. Given investors no longer receive adequate compensation through bond yields, they need greater diversity of returns as well as a more dynamic investment approach.
The ECB has followed its market-neutral approach with remarkable discipline when implementing bond purchases. However, given conditions in the euro-zone corporate bond market, a degree of residual structural distortion is possible.
• Pricing: The ECB’s purchase operations have led to an increase in bond prices and drop in interest rates and yields. In the sovereign space, over 35% of euro-zone bonds are trading at a negative yield. The most recent announcement on the purchase of corporate bonds triggered inflows into the market and boosted bond prices. As a result European investment grade and high yield corporate credit have become expensive relative to US equivalents. While the upside for further outperformance is limited, the vulnerability to adverse shocks has increased. The events in early 2016, when temporary outflows in increasingly illiquid markets led to a surge in volatility, may provide an example of the risks investors are likely to be confronted with going forward.
• Liquidity: As outlined above, liquidity may be hit by the purchase programme as it makes certain bonds too expensive for return-seeking investors to buy. However, the crowding out effect is likely to be limited to smaller-size issuers, while the impact on the broad market should be quite small. Passive funds – that need to buy essentially all bonds included in the relevant corporate bond index – may be relatively more affected in terms of higher transaction costs than active funds, which are more focused on larger liquid issues and have the flexibility to avoid paying the scarcity premium.
• Maturity preferences: The authorities are likely to shy away from ultra-long maturities (with significant credit risk) and maturities below two years, meaning that more bonds in total would have to be bought to achieve the target volume, as redemptions would have to be replaced. Thus, over time, spreads may rally most in the middle of the maturity spectrum. This is important for pension funds using a corporate curve as a liability benchmark.
In the current environment, underfunded pension funds with a mark-to-market for their pension liabilities, for example International Financial Reporting Standards (IFRS) basis, should see their funding gaps widen and their liability hedge ratios decline. This is because the interest-rate sensitivity of their liabilities usually exceeds the interest rate sensitivity of their assets, given the duration gap. The effect could be smaller than expected, as it is not obvious that the long bonds preferred for liability matching will be affected by increased ECB buying as much as intermediate maturities. While the greatest impact on the discount rate is caused by movements at the long end of the curve, changes to the curve’s steepness (tightening more in the middle, where most assets are held) should be considered when designing liability hedge ratios.
In many cases, pension schemes use government bonds and corporate bonds in their matching portfolios. Some also use swap overlays and other liability driven investment approaches to match the duration of assets and liabilities more precisely. Across the euro-zone, liabilities are measured differently. However, market-related discount rates are common, including the AA corporate bond curve and swap curve measures. With government bond yields at low or negative levels, the mismatch towards swap rates has become more severe. In order to reduce the gap, investors will either have to switch from physical assets to swap contracts or increase average yields by taking on more credit risk. Both options are challenging:
• Moving out of government bonds into swaps introduces leverage and investors face problems, such as diminished bank market-making appetite and clearing costs. We advise investors to approach with care.
• Moving into corporate bonds implies taking on credit risk that could lead to further mismatches versus swaps. In theory at least, this is less of an issue for schemes marked against IFRS curves. However, AA corporate bond curve-based liability values are sensitive to the yield on a small number of long-dated AA issues and therefore the matching offered by euro investment grade corporate debt may be limited.
Most importantly, the diminished potential of the euro fixed income portfolio means that its contribution to asset growth is reduced. Closing funding gaps via asset growth rather than increased contributions will become harder.
Given the combination of liability considerations and shifts in key asset expectations, many investors will reassess their asset/liability management before making any changes. This aside, investors should examine their portfolios and determine if a management style shift is needed for this new regime in credit. This may be an opportune time to shift into more compelling areas of credit, including:
• Shift towards non-euro corporate credit: Moving to non-European credit via global credit mandates or dollar credit mandates, on a euro-hedged basis, can help portfolios preserve more capital should euro-zone bonds come under pressure.
• Increase skill: A review of the entire credit portfolio can showcase how much return or risk can be added. Alternative credit can diversify the opportunity set (high yield bonds, loans, securitised and emerging markets bonds) and provide access to specialist investment managers, and thus additional alpha potential. Adopting a barbell approach – more explicit hedging combined with higher return-seeking alternative credit – can enhance the overall portfolio risk/return, while ensuring investors are not just chasing yield by increasing risk.
• Sacrifice liquidity for returns: Shifting some liquid investment grade credit exposure into more illiquid investment grade credit such as structured credit (via structures such as collateralised loan obligations, residential mortgage backed securities) or higher return-seeking illiquid credit (such as direct lending, real-asset backed or to European corporates) can increase diversification and returns.
In addition to being in unchartered bond-market territory, our five-year capital market outlook points out that the risk of adverse market outcomes is increasing. As a result, we are recommending that investors completely rethink their approach to bond investing. The prospect of historically low overall returns persisting means that more effort should be made to eliminate dead assets, where investors are not being adequately paid for taking risks, and to reduce unnecessary costs.
Nimisha Srivastava is EMEA head of investment manager research and Harald Eggerstedt is senior investment consultant at Willis Towers Watson