Bonds are "now priced fairly" to funding - Aon

UK - Pension funds should see improved funding levels under international accounting rules because corporate bonds are now being priced realistically on the back of recent turbulence, according to investment consulting experts.

Chris Erwin, investment principle at Aon Consulting, said although market volatility in July and August may have knocked returns in other asset allocation groups, he believes the improvement to corporate bond should now improve the discount rate applied when valuing a pension fund's assets and liabilities.

According to Erwin, while corporate bond liquidity has tightened, yields have also risen by around 50 basis points which means the rates used to calculated a pension scheme's funding position will look truer to their liabilities.

One the back of recent investment activity, sparked by the US sub-prime funding crisis, Aon has sought to issue update papers to its clients explaining where their financial positions may be when short-term action, in the hedge funds space for example, seemed intense.

However, Urwin believes pension funds are, in some ways, likely to be reassured by the rise in bond yields.

"Until recently, the [corporate bond] market was not pricing in the risk of default and the risk of the credit agency downgrades," said Erwin.

"But [agencies] have been smashed very hard by commentators so they are more likely to be doing downgrades in the coming months. So the yield on bonds has climbed by about 50bp.

Erin continued: "Some see this as an opportunity because it implies 30% of bonds will default and won't meet payments. I have been saying don't touch corporate bonds until now but the market is now correctly priced and this is good for pensions funding.

"It is levelling out and this is important because of the pricing applied to accounting and funding. This is an important freeing up of the market. But it is going to take skills to manage corporate bonds now as liquidity is drying up in everything but government bonds," he added.

At the same time as there has been renewed focus on bonds and its impact on funding levels, Erwin also noted the volatility of returns for hedge funds has also been of particular interest to UK pension funds.

While Aon's wider recommendation is pension funds invest in fund of hedge funds to give diversified exposure via at least 11-12 funds, the levels and investment routes taken is quite varied depending on the status and size of funds too, so there may be some pension funds with what appears to be high exposure to hedge fund losses.

"We have one single order involved in sub-prime that is 50% down, but we have another which has shorted on sub-prime, and that is 50% up on the month," said Erwin.

"We tend to recommend a fund of hedge funds because they are then diversified over 11-12 strategies. Sometimes they prove more correlated over the short-term than the long-term because when there is a dash for cash you sell whatever you can sell. But the amount of investment in hedge funds has not been huge among pension funds and usually not more than 10%. And most have done it as part of their liability defined investment to swap out liabilities against bond yields, or their exposure to the benchmark," he added.

"There is a shortage of liquidity, it has pushed yields up which has made sales a bit hesitant but I can't honestly see why this should last because the size of the market is the same as it was before and is still really confident."

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