EUROPE - Pension funds could be hit by current investment market turbulence more than initially expected because trustees have been expanding fixed income mandates to gain higher returns as well as move assets out of equities.
Although fund managers and investment consultants note pension funds do invest for the long-term, some managers have expressed concern about current contagion across all investment sectors from US sub-prime credit woes because it is likely to affect fixed income yields where investors have sought better returns through expanded fixed income mandate goals and alternative investments.
Sajiv Vaid, credit fund manager at Royal London Asset Management, is predicting it could be approximately two months before market turbulence really calms, in part because summer months have traditionally seemed turbulent when there are fewer trades.
However, Vaid, told IPE in light of volatile conditions and the impact sub-prime lending could have across leverage, for example, pension funds might see their fixed income investments affected by recent damage to the credit and equity markets because some now have higher exposure to leverage than perhaps two years ago and AA-rated corporate bond yields are falling.
"There has obviously been a trend towards fixed income assets and corporate bonds [by pension funds] and increasingly in the last two years we have seen a trend where pension fund managers have been trying to expand the [fixed income] mandate, extending to high-yield and then into alternative investments, encompassing a multitude of factors such as hedge funds and leveraged loans.
"What we have seen is volatility picking up. If pension funds are true to their weighting, they should be able to see through this volatility and I do not think this is a turn in the cycle, but it is possible questions will be asked - are [pension funds] investing in CDOs, sub-prime, were they motivated to extend the mandate to give [managers] the flexibility? How to manage that risk going forward will be key for pension funds," he continued.
"Bond] yields have gone up, and I think this may make pension funds aware of the imbalances this might bring to their liabilities. I don't think the trends towards fixed income will change but it is a wake-up call to be aware of the risks," added Vaid.
It's a sentiment echoed by Margaret Frost, a former bond manager and now head of global bond manager research at Watson Wyatt, as she noted while pension funds would usually invest for the long-term, and are therefore less likely to act on short-term volatility, some pension funds may have been caught in the crossfire of trading.
Frost said there are still thought to be pension funds which had sought to lock in earlier gains from equities in May and transfer assets into bonds but who might not yet have completed the transition process.
"We are still in the eye of the storm. We could see an effect where there is some good and bad news every week, creating further turbulence. And it is hard to know where the bid is because a lot of the people involved in these markets are still on the beach," said Frost.
"The one advantage is pension funds take the long-term view. But they have suffered some fierce blows in the past eight weeks. For sound reasons, they have diversified into alternatives so the pain could be felt across a number of asset classes, particularly as many pension funds have moved into long-short positions and leverage. Long-dated gilt yields which looked attractive in May so selling equities and going into bonds has serious consequences now," she continued.
Heavy losses in the equity markets over recent weeks are already likely to have reduced the funding levels of major UK pension schemes, according to consultancy Lane, Clark & Peacock, based on earlier calculations related to equity weightings alone.
Bob Scott, partner at LCP, presented findings earlier this month suggesting the fall in the value of equities in July to 6200 points had wiped around £18bn from the £350bn total value of FTSE 100 pension funds, based on an average FTSE 100 pension fund weighing of 57% in equities.
Markets have fallen again on Thursday - on the back of US sub-prime credit jitters and fears of the collapse of another major sub-prime lender - and are currently sitting at least 2% lower on yesterday's trading, as the FTSE All Share index is at 3061.1 by 13:30 GMT and the MSCI Euro index is down 2.2% to 1,242.
So based on LCP calculations conducted for IPE, Scott is predicting a further £8bn could potentially have been wiped off the funding levels of pension funds since the end of July through straight equity trading alone.
However, this looks only at the potential losses on equities and does not take into account the impact of investments in hedge funds, alternative assets, as well as leveraged loans or other diversified fixed income assets held within bond mandates so losses could be lower still, according to Scott.
"The way [companies] report their pension funds in accounting means they give a breakdown [of asset allocation] but they don't necessarily split that out in their accounting," said Scott.
"It is possible they have moved they pension scheme assets into alternatives and we do not have any information about that. That said, pension funds are more likely to invest in a pool of hedge funds, so one hedge fund is less likely to have a material impact on underperformance," he added.
Elsewhere, government bond prices are continuing to rally but lowering yields further. In the UK, the August 2017 8.75% UK gilt, yielding 5.05%, appears to be most popular among UK investors as its price rallied a further 0.59 to 128.79 at 12:00 CEST and the April 2017 4.25% Bund rallied 50 basis points to be priced at 99.8 at 14:45 CEST.
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