Are bonds the cool asset class?
Suppose you are a UK widget manufacturer, looking at the assets of your funded defined benefit (DB) pension scheme. Like all other widget manufacturers, you closed the scheme to new hires a year or two ago and opened a defined contribution (DC) scheme instead. However, the DB legacy lives on and will continue to do so for a number of years yet, well at least until the current senior management have retired.
You look at the yearly cashflows needed to meet the pension liabilities. They seem well-defined. For the next few years, you know pretty much what the total pension payroll will be, and you know the contributions that you are budgeting for. And in fact, subject to some uncertainty about how long your pensioners will live, you can predict the pre-inflation cashflows with a high degree of confidence quite some way into the future, certainly more accurately than the cashflows from many of your other widget-related company investments.
You would like to have some spare money in the pension kitty, to help ease out some of your workforce when times are lean for the company. You used to do this by using pension scheme surplus to finance enhanced early retirement pensions for the people you were making redundant. But the cost of doing this is beginning to look less and less attractive, and you are being harder-nosed with your redundant employees than you used to be. In any event the surplus has disappeared and having surplus money tied up in a pension plan is a luxury that you really cannot afford.
So, when it comes to investing your pension fund assets what you really need is an investment that will produce a known income, largely index-linked, which exactly meets your known pension payments. Sounds like you need some bonds, including a substantial index-linked component.
Bonds - the panacea?
This, in part, is the logic that drove Boots plc, and its pension scheme trustees, to move entirely away from equity investment and to invest in bonds (and more recently, in swaps that will provide inflation protection). Yet after a few years of appalling equity returns, there has been some drift in UK pension funds into bond investment, but nothing like the wholesale approach adopted by Boots. Boots is regarded by many as the maverick which happened to be lucky with its timing. So what is holding back the rest?
Pension trustees and company management are still chanting the mantra ‘equities will outperform bonds over the long term’. And the mantra is still true – you do expect higher equity returns because you accept higher risks. Any pension trustees or company management who use asset-liability modelling techniques to understand pension expenses over the long term, say 10 years or more, will find that they can reduce the average cost of their scheme for apparently little risk by maintaining a high equity content. The fact that the ride over the next 10 years could be bumpy, and the reward is not guaranteed, does not yet seem to be a major concern.
Pension schemes have been facing increasing costs over the last five years for a variety of reasons. Increasing longevity means that pensions will need to be paid for longer. A fall in expected returns has increased the amount that needs to be saved now for future commitments. And finally, there are those equity-driven funding deficiencies that need to be made good.
For a mature pension scheme, an additional 1% investment return can make the difference between a 10% employer contribution rate and a 30% rate. There are a lot of businesses that simply cannot stand the higher level of cost: the widget maker’s profit margins are just not that wide. So, the choice is a stark one – carry on the way that we always did, with a high equity content targeting a high return or walk away from the plan and let beneficiaries take most of the losses. Many companies are continuing with the ‘double or quits’ gamble, irrespective of the risk that the current asset strategy poses for the business and beneficiaries.
The only thing that might change this is if the legislators decided to move the priority of pension liabilities up the company’s list of creditors. The downside risk associated with pension losses becomes of greater interest to the company’s other creditors and may change the terms on which they were willing to do business. But the UK government does not seem willing to contemplate such a radical change for the time being.
Some trustees have seen the fundamental attraction of moving to bonds. But there is little attraction in moving now out of apparently underpriced equities and into apparently overpriced bonds. Trustees have already suffered the disappointment associated with following equity markets downhill. The potential pain associated with locking in those losses and then watching bond markets drop is too much for many trustees to bear.
As things stand, we do expect some continuing movement by pension schemes into bonds. However the allocation to bonds will be nothing like as high as for Boots or, for that matter, as high as the levels that are regarded as appropriate in a number of other continental European countries.
So what’s cool in bonds? With reduced expected returns on equities, pension trustees are conscious of the need to make all their assets, including the bond component, work harder for them. These are some current themes.
o Corporate bonds: with the UK corporate bond market now larger than the government bond market, the arguments for diversifying the bond portfolio into corporate bonds are strong. The finance director has also noticed that, with pension liabilities under modern accounting standards now measured by reference to AA-rated bonds, these securities will give a closer match between a plan’s assets and liabilities, and hence a more stable accounting expense. Financial theory says that this may smooth the disclosed profits but adds no economic value.
The one fly in the ointment is the downgrading of a significant number of bond issues in the last year, with a consequent effect on returns.
o Added beta: some pension trustees are looking for ways of trying to match part of their assets and liabilities by using a bond portfolio, but then finding a way of obtaining some outperformance relative to government bonds in a risk-controlled way. In some cases this is again simply a call to use corporate bonds of an appropriate duration, but other more complex products, involving swaps and/or hedge fund strategies, are also up for discussion.
o High yield: the risk associated with junk bonds still stigmatises them in many trustees’ eyes, but some recognise that a well-diversified portfolio provides yet another source of return with risk characteristics that differ from equities.
The bond part of the portfolio is under scrutiny as never before.