As well as making sure the actively managed portions of their equity portfolios are working as hard as possible, institutional investors have also become more focused on how their fixed-income portfolios are managed.
“In terms of targeting outperformance, I’ve noticed a real shift in the last few years,” says Paul Craven, head of UK business development at bonds specialist PIMCO. While in the 1980s, bond managers were often focused on beating peer group benchmarks, in the 1990s their sights were set on outperforming gilt indices by modest amounts; these days there appears to be a significant trend to higher alpha, often 1% to 1.5% over composite or bespoke indices.
“Certainly from a bond perspective, a lot of investors are now interested in making their portfolios work harder,” says Craven. “In order to do that in the bond markets, you have to do things differently from how they were done traditionally in the UK.”
Back then, investment was more or less limited to government bonds and some highly rated corporate bonds.
But now, for trustees to get the high returns they need, they need to use the full fixed-income tool kit, he says. They key is to use certain types of bonds tactically and in a small way, including sub- investment grade bonds and emerging market debt.
“As far as PIMCO is concerned, our resources have allowed fund managers to use the full tool kit for years,” he says. “Our experience shows this can achieve higher returns without an increase in volatility.”
While investors are seeking alpha through specialised active management in both the equity and fixed-income space, boosting return levels from bond investments calls for different techniques.
Fund managers using equities to achieve alpha will often create a portfolio with fewer stocks than would traditionally be held, but the opposite can often be effective for bonds.
“In bonds, we think if you want higher returns without a commensurate increase in risk, then you generally have to hold more of them in a diversified way and incorporate a number of different strategies,” says Craven.
Swaps can be useful in allowing a fund manager to pinpoint investment views more closely than with an underlying bond, he says. And more generally, there is a much greater willingness for fund managers to use derivatives, he says.
The way bonds are seen in the UK has definitely changed over the last few years, says Craven. While they were seen as a slightly sleepy asset class that was largely there for diversification purposes, now they are looked at as a much more important asset class.
During the many years of the bull market, the rising tide lifted all boats, but now investors and fund managers are having to look much more closely at where value can be added.
“What the equity bear market of 2000 to 2003 did in every part of the market was to expose the frailties behind many assumptions held for the last two decades,” he says. “You can’t rely on the past to pay pensions – all assets need to be made to work harder and smarter.”
John Stopford, head of fixed income at Investec Asset Management, says the way pension funds are investing in bonds is going down two paths. On the one hand, there is the trend towards passive matching of assets and liabilities, as plans strive to remove their mark-to-market risk.
“But on the other hand, they realize that by doing that they’re locking into quite low returns,” he says. In real terms, gilt yields are historically very low.
A lot of pension funds cannot afford to do this, because of the deficits they are carrying. “By locking in now, they’re crystalising their deficit,” says Stopford.
Pension funds are looking to see if there is an alternative, where risk can be reduced and they can earn a decent return. The answer is seen in a combination where they add risk at the margins in order to increase returns. “They’re increasingly looking at diverse sources of active return, in fixed income and also in currency,” he says.
Fixed income is good for diversification, because there are so many different ways to invest. There are different parts of the yield curve, different country issuers, government and non-government, emerging market and high yield. And within that there are different high-yield names and different emerging markets names, says Stopford.
“Fixed income offers an alternative way of adding value and added return is increasingly important,” he says.