Credit: Qualities for the long term
Madeline Forrester makes the case for investing in high yield as part of a longer-term strategy
The tumultuous events of the past decade, such as the bursting of the dotcom bubble and more recently the financial crisis and attendant severe global recession, have presented managers of pension funds with ever greater challenges in meeting their objectives. Coupled with this, regulatory changes have affected the investment community. Against this background, the ability of assets to generate sufficient returns to meet liability funding obligations has waned, particularly as these have often proven to be higher than predicted. All of these developments and attendant uncertainty have contributed to the growing popularity of an asset-liability matching (ALM) approach to managing pension portfolios.
Fixed income securities have long been a preferred investment area for pension funds, especially government bonds and index-linked bonds, due to the facility of constructing a low-risk, cash flow-matching portfolio, with the objective of producing the required cash flow where it is needed. In that way, the asset cash flows are roughly equal and timed to coincide with the liability cash flows. However, a big drawback to these assets is the limited range of government securities available, while any match using conventional bonds and index-linked securities is likely to be awkward and not extend far enough into the future to cover all liabilities.
Furthermore, all investors, including those of pension funds, have come to recognise the benefits of diversifying portfolios to reduce risk, through the use of, for example, holdings in supra-national bonds, equities and corporate bonds. Put simply, matching can be made more accurate by including more assets.
Against this background of change, high yield is increasingly being looked at by pension trustees as an attractive option for addressing some of the challenges of successfully managing pension funds. High yield offers long-term investors a number of benefits relative to both other fixed income securities and equities.
For instance, their performance shows a relatively low correlation with other fixed income assets. And while they show a higher correlation with equities than other fixed income assets, in normal market conditions it is still relatively low. This low correlation with other assets is easily understood when one considers that high yield bonds benefit from improvements in the economic environment and rising risk appetite in the same way that equities do, yet their high yields offer investors a degree of protection from the associated rising interest rates and inflation that are not available to government and corporate bond investors. This is an especially important consideration for ALM investors, where rising interest rates can be a significant stumbling block to ensuring that returns match future obligations.
Furthermore, high yield is an area where companies with stable cash flows can make their issues attractive investments. One does not necessarily need to find businesses providing strong top-line growth to see good returns. While high yield corporate securities share some characteristics with equities, they are ultimately bonds and therefore provide investors with defensive characteristics, notably a coupon. Nevertheless, high yield securities are like equities in that when equity markets rebound, there is also a resurgence by high yield assets.
Volatility may also be a consideration for an investor looking to diversify or minimise risk. Equities enjoyed a period of strong outperformance from the mid-1990s through to the bursting of the IT bubble in early 2000, and a subsequent period of outperformance from 2002 to the start of the most recent financial crisis in 2007. Over the same period high yield bonds have delivered investors a level of volatility closer to that of the other fixed income assets such as government and corporate bonds. In fact, while equities have enjoyed some of the biggest gains over this period, they have also been by far the most volatile asset class of the four - a significant drawback as an investment for pension fund, where trustees look to provide reliable returns to cover expected liabilities.
Beyond the issue of choosing high yield as an investment in a multi-asset portfolio is the question of what is the most productive approach to managing it for a pension portfolio. For instance, should a manager maintain a long-term proportion of a portfolio in high yield as a strategic holding? Or would it be better to adopt a more tactical strategy of actively adding the asset during particularly attractive periods of performance, such as extended bull markets, while substantially cutting back during episodes of volatility?
Despite the fact that high yield does possess singular characteristics setting it apart from other asset classes, it is like them in providing more consistency in performance over a longer-term perspective. For example, while high yield bonds tend to be lowly correlated with equities on a long-term perspective, they can prove more highly correlated during periods of high market volatility. The real appeal of high yield bonds is their ability to provide attractive risk-adjusted returns on a longer-term horizon, particularly relative to equities. And from that perspective, we believe the case for investing in high yield as a strategic asset becomes much more persuasive.
During periods of severe volatility, such as took place early in the past decade and during the years 2007-09, almost all asset classes can be subject to unpredictable, and disruptive movements. In the second period, for example, the safe haven appeal of government bonds was periodically undermined by worries over supply concerns amid soaring budget deficits. It has made ALM during these times a much more difficult endeavour. However, attempting to use high yield as a tactical asset to achieve performance objectives to address this unpredictability, we believe, is more likely to suit the investment style of a more speculatively managed portfolio geared to achieving high alpha returns.
Of course, having said that, all actively-managed pension funds seek to generate as much alpha as possible within the constraints agreed for a particular portfolio, if for no other reason than to provide a cushion for those times when poor performance leads a fund to undershoot its performance target. Therefore, it is clear that managers will make use of tactical strategies to maximise the performance that they get from their high yield investments during those periods of optimal trading conditions in the high yield market.
In the final analysis, arguing whether the right strategy for managing high yield in a portfolio is a strategic or tactical one is really not a straightforward either/or choice.Overall, maintaining high yield as a strategic asset in a pension fund is clear, but there is also a case for periodic tactical adjustments to optimise benefits to the fund and stakeholders as well, when these are performed within the agreed parameters and constraints of the fund. What is clear is that whatever approach one takes, owning high yield makes sense as an integral part of a pension portfolio.
Madeline Forrester is head of global institutional business at Threadneedle