It seems that we have now generally accepted that any discussion of pension fund investment strategy will centre around bond investment. And for a person brought up with the cult of the equity how can one possibly make investment interesting anymore. Surely bonds are boring!
Well actually yes they are and no they are not. As they say - it all depends. It really does depend on what you want to do with your bonds. One solution to the problem pension funds face today is, as we considered last month, to liability match.
Surely then you simply buy the bonds which most closely match your liabilities, collect the income and wait for them to mature. Ah, but is it that simple. What bonds should you buy? How do you match maturity? How often do you monitor what is happening to your liabilities? The more you think about it, the more questions arise.
In fact for most pension funds bonds are now anything but boring. Actually, a great deal of education is required. Do most trustees or boards really understand swaps, credit derivatives, convertibles, mezzanine, CDOs, mortgage-backed securities and asset-backed securities, ETFs, the high yield market and emerging market bonds?
With many schemes in deficit and interest rates rising, now is not a great time to be investing in government bonds. So the whole gamut should be considered. At the end of the day investment managers must trust that it will be familiarity that will breed confidence and not contempt.
Indeed, according to Denis Gould, the UK head of fixed income at AXA Investment Managers and to misquote Dickens. “It is the best of times, it is the worst of times.”
The best of times because the opportunities to add value are better than ever and the worst of times for trustees trying to keep up with the ongoing developments. With their main investment offices in Paris and London, I can’t think of a more appropriate company to quote from A Tale of Two Cities.
One of the most common misconceptions with bonds is that when interest rates go down all bonds do well and that conversely when rates increase all bonds do badly. In fact in 2003, bonds as a whole performed badly for many funds, providing the lowest ranked return of all asset classes.
In 2003, according to Callan Associates, the Lehman Brothers Aggregate Bond return was only 4.1% and yet emerging markets still produced a respectable 23%.
I claimed last month that although bonds can be said to be the closest match for pension scheme liabilities …. any efficient frontier shows that bringing in a small proportion of equities or indeed almost any other asset class will reduce risk.
The same theory also applies within an asset class and therefore whilst holding both equities and bonds can reduce risk to the portfolio as a whole, we can also add value through diversification within the bond portfolio. Indeed the lowest risk bond portfolio is not one comprised entirely of government bonds. In fact whatever your expectations as regards interest rates and duration, diversification reduces risk.
Gould has pointed out that even introducing a more volatile asset is likely to reduce overall portfolio volatility. He describes it as “adding value through diversification”. So the key is bringing together assets that are diversified. One can say that it is good risk management that leads to better asset management.
However, for quite a number of funds this approach may not be aggressive enough. With so many funds in deficit and companies wanting to keep contributions as low as possible, the emphasis for some will be a focus on alpha strategies. Benchmarks are important in bond investment but the choice of benchmark has traditionally not been easy.
Turning from an arbitrary benchmark which depends upon stock issuance makes little sense to a pension fund. Benchmarks should be liability related but not many funds will feel comfortable to see their assets reduce when interest rates rise. You can be told that relatively speaking you are as well off as you were before as your liabilities have also reduced but funds want more and alpha strategies, even in bond investment, can hopefully provide that extra comfort factor.
But with alpha investment being a zero sum game are many funds destined to be disappointed? This could well be the case but many pension fund bond investors in the future will not be profit maximisers. These funds will be benchmark-led investors, in bonds because they are told to be so. They will follow the market up and follow it down. Surely this will leave many opportunities for the more opportunist investor, one who can look objectively at real diversification and not just duration, curve or even credit quality.
I cannot see hedge funds and other alpha strategies in bonds dying out for some time and bonds are certainly not boring for the professional.