BlackRock's Charles Prideaux examines the alternative investment approaches for pension funds in a world of ever-declining government bond yields.

Fixed income investing has rarely been more demanding for pension funds and other institutional investors. In response to the unique confluence of secular and cyclical challenges facing the global economy, central banks across the G7 economies have lowered official rates to 1% or below, and longer term government yields have declined sharply. Other high-quality fixed income assets - for which government bonds serve as the yield benchmark - have followed suit. Some investment grade corporate bonds are paying yields last seen in the mid-1960s.

So how can institutional investors respond? As well as diversifying into other yield-generating asset classes, pension funds can also increase the yield potential from their fixed income allocations. In practice, this involves adjusting the quality constraints on their corporate credit allocations to allow below-investment grade bonds and loans. There are good reasons for doing so. Non-financial corporate balance sheets, in contrast to those of banks, are solid at this stage of the credit cycle. Leverage has been steadily reduced and debt, at 3.9x earnings, is a full multiple lower than two years ago. Liquidity is also very strong, with the ratio of liquid assets to short-term liabilities at the highest levels since the 1950s.

The relative strength of high-yield issuers reflects a combination of expense discipline, cautious investment spending and earnings retention. Default rates remain at historically low levels - just 1.9% of the universe by volume in the 12 months ending November 2011, compared to a long-term annual average of around 4.5%. Rising credit costs and the weakening growth picture will likely translate into higher defaults in 2012, but our current projection is only for a modest increase to 2.7% this year.

The bank loan market is also attractive. Loans pay coupons that are indexed to LIBOR and typically offer greater protection to investors through covenants and collateral security. The market has been less in demand recently given that short-term interest rates are projected to remain constant for the near term. But with a yield to maturity of just under 6% and a meaningful current coupon yield, bank loans represent an attractive source of income for investors concerned about the potential for rising rates at some stage in this market cycle.
Another compelling opportunity for income investors is to reduce their regional bias to home markets - where funding pressures on sovereign issuers have become intense - and broaden their allocation to emerging market (EM) debt. Sovereign credit concerns in developed markets (DMs) are, broadly speaking, a function of too much debt, too little growth in the medium and long term due to deleveraging and weak demographics, and less flexibility to offset the growth impact of fiscal tightening as policy options are largely exhausted.

EM countries have much healthier fiscal balances than their DM counterparts and debt issuance to fund these smaller deficits should be easily absorbed by the market. Many EM countries, particularly the commodity exporters, have shifted to a net external creditor position over the past decade, and the strong growth in foreign exchange reserves will provide a powerful defence against external shocks.

These developments have driven an average three-notch rating upgrade of EM sovereigns over the past 10 years, with the result that external EM debt is now an investment-grade-rated asset class. Furthermore, with concerns around the solvency of some DM sovereigns, and their ability to refinance maturing debt in public markets questionable, rating convergence with the DM sovereign universe is likely to continue for years.

Opportunities to invest in other higher yielding sectors of the fixed income markets could emerge over the next year or two as banks work to shrink bloated balance sheets by disposing of risky assets. One area we continue to monitor is the market for non-agency securitised bonds backed by residential and commercial mortgages, where new issue supply is limited and liquidity can be challenging.

The focus on income generation has naturally led pension schemes to other asset classes amid the current environment where high quality yields are so low. However, there are still segments of the bond market with strong income potential for which the long-term investment case is compelling - but investing in them means institutional investors must remove the shackles from their fixed income allocations.

Charles Prideaux is head of EMEA institutional business within BlackRock's global client group.