The euro-zone crisis has reminded German pension funds that bonds carry risk, as Nigel Cresswell and Alexander Zanker explain

The euro debt crisis has made it clear to investors that government bonds do in fact bear credit risk. For German institutional investors with a heavy focus on fixed income, this leads to a paradigm shift in thinking. The traditional view of building bond portfolios primarily by issuer and by credit rating can no longer be considered the best way to manage risk and a reappraisal of bond portfolio construction is necessary.

German Pensionsfonds have been successful as pension vehicles for the last 10 years or more. Statutory regulations and an appropriate tax framework have facilitated the funding of pension funds within an insurance vehicle. Many German corporations have thus used the opportunity to transfer their current pensioner obligations and the past service of actives to Pensionsfonds. Furthermore, it has been possible to create efficient structures by utilising Pensionsfonds in combination with other funding vehicles, such as CTAs or support funds. As a result, Pensionsfonds currently manage over €25bn in assets.

German pension vehicles’ fixed income exposure concentrates mainly on European government bonds, national and supranational bonds, as well as covered bonds and high-rated corporate bonds.

Those pension vehicles that anticipated the euro crisis, and recognised early that government bonds are not credit risk-free reduced their overall risk exposure to these instruments as a first step. Many  pension vehicles targeted periphery bonds in this risk reduction process, and as a result have a greater proportion of government bonds issued by the core euro-zone countries and, in particular, German government bonds. Exposure to Italian and Spanish bonds was carefully assessed but, in light of their substantial weights in European bond markets, were typically only slightly reduced. Nevertheless, some Spanish government bonds, for example, were replaced with other covered bonds due to a perceived improved risk/return potential.

Concentration risk
Following the removal or reduction of targeted credit risks, the next step has been to rebuild bond portfolios in alignment with the new economic framework. Rising uncertainty in European government bonds has led to a requirement for higher diversification. But how can this be implemented in practice? An approach of selecting only AAA bonds is problematic, given the often delayed reaction of rating agencies and the ‘jump-step’ nature of such a risk management approach. Furthermore, given the limited asset universe of AAA entities, setting up AAA limits contradicts diversification principles, which aims to minimise risk, by introducing considerable issuer concentration risk.

Fundamentally, investors can no longer assume that bond issuer type (government, corporate, emerging market etc) is synonymous with bond risk levels. All bonds, regardless of issuer, carry a degree of credit risk. No bonds are risk-free, they just sit at different places on the credit spectrum. Similarly, recognised assumptions, often hard coded into investor bond portfolio construction, no longer hold true - for example, the perception that developed market bonds are less risky than emerging market bonds. The credit worthiness (and ratings) of many emerging market issuers has strengthened considerably, and we believe that this trend will continue, given on-going positive economic dynamics and demographic developments. Similarly, government bonds are not necessarily safer than corporate bonds, and the rule of thumb that corporates’ ratings were capped at the strength of the relevant government bonds no longer holds. Government bonds of the euro-zone core countries as well as emerging market bonds and corporate bonds can overlap on the credit spectrum.

This creates particular challenges for pension vehicles that were originally long-term investors with a buy-and-hold perspective. Henceforth, they will be required to take a more dynamic view of their portfolio to ensure their risk management fits the new paradigm, both at a portfolio level, but similarly at a strategic asset-allocation level.

Bond portfolio construction
A traditional method of constructing bond portfolios by asset type (eg, government versus corporate bonds, developed market versus emerging market) can no longer be seen as the best way to manage credit risk.

A new approach to risk management is required instead, based fundamentally on creating a bond portfolio constructed out of multi-risk layers, determined by the risk of the underlying instruments, rather than relying on the type of issuer, or rating, as a proxy for this. Such an approach further facilitates a high degree of customisation to fit the specific needs of the given pension vehicle - for example, the minimum risk layer may be used to hedge the liability side in line with the specific hedging wishes of the vehicle or sponsor, while a broader range of bonds can target  additional returns above the liabilities. As explained above, such an approach requires a more dynamic approach at the portfolio level, in managing the risks on an ongoing basis.

Dynamic approaches
Entities with professionalised investment approaches and the necessary resources are similarly increasingly implementing a more dynamic approach towards their asset liability management (ALM) processes.

Traditional ALM studies have become a standard in the industry, and indeed have become hard coded within the regulatory framework following the BaFIN guidance note R4/2011. Some Pensionsfonds have gone beyond the minimum requirements to integrate other pension funding vehicles (such as CTAs) into their ALM process, and increasingly more dynamic approaches are being utilised.

Dynamic approaches to asset liability management involve establishing, ex-ante, a central journey plan or flight path, which determines the long-term goal of the pension vehicle. This plan may include thresholds, around which risk decisions may be taken (eg, increased hedging), either in advance, or at the point they are breached. However, such a plan cannot be static, based purely on the capital markets at the outset of the analysis but, instead, needs to be regularly updated - both to reflect the actual ongoing solvency level of the entity over time, and also to reflect changing capital markets (and hence necessary changes to future assumptions).    

Under such an approach, risk budgets are not constant over time but, instead, are adjusted to allow for de-risking or re-risking as the solvency of the vehicle deviates from its central path. In addition, it gives the entity the ability to take risk over time, as well as opportunities in the capital markets. 

Pre-requisites for such an approach are to be able to set goals that can be monitored and be able to recalibrate the strategy over time, on a timely basis. Forward-looking risk measures that represent core risks are important for satisfying the first criteria. Indeed, the 2011 Towers Watson study ‘Pension-Risk-Management und Anlage von Pensionsvermögen’ shows that 80% of companies now use forward-looking risk measures at least quarterly in monitoring assets, whereas only 50% do so for monitoring liabilities.

With regard to recalibration, pension vehicles need appropriate structures and processes that allow them to make good decisions. For many vehicles, the right approach is to do this as part of the planning process by introducing threshold triggers which can automate aspects of  implementation. Under this approach, retaining some safety checks is also advisable. 

Only a few vehicles have the timely structures and ability to implement at speed to facilitate the decision making and implementation at the point in time at which a threshold is triggered.

Although these required processes and structures are more costly to implement, pension vehicles can achieve a better risk/return profile by reacting quickly to environmental changes.  Indeed, studies show that pension vehicles with enhanced governance structures can achieve better returns in the long term under the same risk profile.

Risk management and investment strategies are at an important juncture for pension entities. The euro-zone debt crisis has challenged several established ideas and now requires them to reconsider the most appropriate way to structure their bond portfolios. Given their extensive reliance on such portfolios, this is now of critical importance for the on-going success of these vehicles and, in a changed economic world, a more dynamic approach has become a necessity.
This will be required at both a portfolio level - a buy-and-hold approach to risk management is no longer appropriate - but also at the overall strategy level. Risk management increasingly requires ex-ante planning, rather than ex-post reactions. In turn, this requires higher levels of governance and more efficient governance structures. Our experience so far is that pension entities have begun moving towards structures that can monitor and manage risks on a forward-looking basis, for both liabilities and asset. But there are still too many trying to manage risk using the rear-view mirror instead of looking forward.

Nigel Cresswell is head of investment consulting and Alexander Zanker is senior investment analyst at Towers Watson, Germany