If interest rates rise what should pension funds do? The answer for the majority of pension funds is likely to be the same - nothing.
For the minority - those for whom substantial bond portfolios are actively managed by internal pension fund investment staff - the answer is slightly different: probably nothing.
Interest rate changes are one of the most important drivers of the bond markets and bond yields are the dominant component of total return. Why then is doing nothing in the face of rising interest rates an intelligent strategy? To understand why less action is likely to be more productive three different points must first be clear: the difference between strategic and tactical management, the difficulty of timing, and the sources of value added in bond portfolios.
A pension fund that is 100% funded and is running a minimum risk portfolio (relative to its liabilities) has no reason to take action in the face of rising interest rates.
Coupon cash flows matching the current and projected liabilities of the fund will be unaffected by changes in the price or running yield of the underlying bonds.
In the more usual situation of a fund that is in surplus (whether positive or negative) a rise in long bond yields should be good news because it should be accompanied by rapidly rising surpluses. This occurs because the fund’s liabilities are much more sensitive to interest rate changes than its assets and so decline more in value when interest rates rise. The resultant narrowing of the duration gap between assets and liabilities should make it less painful for pension funds to move to a minimum risk portfolio.
It is tempting in the face of rising rates to defer planned bond purchases so that higher yields can be locked in at a later date, and/or to rotate out of bonds into other asset classes. Timing as always, is the critical consideration.
When are rates going to rise? And are bond yields going to follow? These are tactical issues for the active manager, not strategic issues for the pension fund.
The steady rise in US policy rates over the past year has been very clearly telegraphed by the Federal Reserve.
And yet we saw, until recently, a decline in 10 and 30-year treasury yields with an overall flattening of the curve. Global bond managers have been steadily shorting the sensitivity of their portfolios to increases in long-term rates in all the major markets as shown in the chart below.
Our survey of European bond managers shows similar defensive positioning as the outlook has become more bearish.
The reason for this is that interest rate timing is hard – really hard.
Basically there’s just one decision involved and you’re either right or you’re wrong. There is no way to diversify the forecasting risk as is the case with a portfolio of equities or credits, for example. So if you’re right you’re a hero, if you’re wrong you’re a zero.
With so many economists and investors focused on the interest rate outlook, and with all the relevant data in the public domain it is in our opinion very difficult to develop a competitive advantage in this area.
The success – or lack thereof – of active duration managers in the US is illustrated in the chart below. Compared with sector rotation managers the interest rate timers add materially to portfolio tracking error but add relatively little excess return. (It should be noted that sector rotation managers use interest rate timing in their process too, but typically place far less emphasis on it than do active duration managers).
While we do not have such good quality data for European managers, we have no reason to believe that they will fare any better than their US counterparts. In the case of internally managed bond portfolios, these difficulties are likely to be compounded by a relative lack of resources available to most in-house pension fund investment teams.
If active duration is too risky to be worthwhile for most investors, how should they attempt to add consistent value to their bond exposures?
Our experience suggests that the key to consistent alpha, in bond portfolios as elsewhere, is to combine several uncorrelated excess return streams.
This can be achieved though a multimanager structure, or possibly from a single manager that employs multiple strategies in its portfolio management process.
These strategies can be broadly classified as issue selection, sector rotation, yield curve positioning, and yes, active duration management.
Our experience suggests that strategies which focus on changes in the slope of the yield curve offer superior risk-adjusted returns when compared with strategies that seek to judge the future level of interest rates.
With credits now accounting for over half of the UK benchmarks becoming increasingly important in continental benchmarks, issue selection has come to the fore in recent years.
Sectors and sector rotation strategies are not yet as developed as in the US but the market and the managers are changing rapidly. Also, expanding the investment opportunity set beyond domestic bond markets will for the skilful manager mean additional alpha potential from country and currency plays.
To succeed in interest rate timing requires considerable expertise. We have committed huge research resources to finding the best managers and strategies and in our experience such expertise is hard to find.
Consequently our multi-manager bond funds use managers that emphasise other strategies that have more attractive risk/return expectations.
Most pension funds should be able to spend their time and their risk budgets in more profitable activities.
Steve Wiltshire is chief investment officer Europe, with Russell Investment in London