Investment grade bond spreads have narrowed, government bond yields are expected to stay low for even longer, so where can defined benefit schemes still find the income they need to pay pensions? 

 

Central bank support and a debt burden not seen in peacetime are expected to keep government bond yields low for even longer – what some now call ‘low forever’. 

The UK sold its first negative-yielding gilt in May, and while the bank rate is just in positive territory, there is a possibility that this too could change. It would not be alone: many developed nations – with the notable exception of the US – now require investors to pay for the privilege of lending money to them. 

 

 

So has government borrowing amid the Covid-19 pandemic deepened the trend of ultra-low interest rates, which has been with us since the last financial crisis? And what does this mean for DB schemes that are increasingly reliant on investment income as they become cash flow negative?

 

 

For pension funds, the difference between the financial crisis and now is that they are 10 years further down their derisking path. In 2010, defined benefit schemes held a roughly equal percentage of their assets in equities and bonds – in fact, they had slightly more equities than bonds (42% and 40.4% respectively) according to the latest Purple Book. Now, the equity exposure is less than half that at 20.4%, while on average, a whopping 69.2% is held in fixed income, making the hunt for yield ever more important.

 

“By and large if you want secure income, it’s somewhat more difficult than it used to be,” says Graeme Caughey, a professional trustee at Scottish Pension Trustees. 

However, although rates of income have collapsed, he says some schemes have been able to maintain cash flows by simply managing their bond maturities – keeping bonds for redemption and “just noting that some are due this year, next the year after, etc”, potentially indicating a move towards buy and hold.

 

 

Another part of schemes' income stream this year has also come from real assets and certain credit instruments. 

Senior adviser at MJ Hudson Allenbridge, Anthony Fletcher, says schemes have always had an element of income from sources other than government bonds, such as infrastructure, private credit, investment grade credit or high yield bonds. 

But while this used to be an area only the more sophisticated pension funds would explore, “now everybody is being forced out into that field. If they want yield, they are having to look around for it”, says Fletcher, and with yields from investment grade also being “incredibly low”, more pension funds are looking higher up the risk curve for returns. 

 

 

"Investors are widening their investment parameters. If you were investment grade only before, you now entertain the idea of sub-investment grade. If you didn’t like subordinated financials, you now might. If you didn’t have high yield, you want to look at high yield,” he observes, with some managers offering opportunistic strategies to provide this. 

 

As with low interest rates, this trend has been in place for a while, but has been accentuated by Covid-19. For the most nimble investors, the crash in March even offered opportunities as they used it to increase credit risk. 

 

The very low interest rates also mean that some of the local authority schemes Fletcher advises – which have the advantage of being open to new members – are, in what could be a sign of things to come, once more looking to dividends as a source of income, even though these are not guaranteed. 

 

 

As investors extend the range of fixed income instruments they are prepared to consider, this also means accepting more risk. “It would be a surprise if default rates didn’t go up” as a result of the pandemic, says Fletcher, but adds that some of this could already be priced in. 

 

While some covenant specialists predict that the real cash crunch for companies is yet to come when they see themselves forced to invest for growth, Fletcher points out that many central banks are buying corporate bonds, providing special lines of credit to companies.  

 

There could well be an uptick in companies defaulting on their bonds but these will be selective, he says. “The defaults may not be as high as you’d expect in a normal credit cycle because so much money has been made available,” he believes. 

 

 

For Paul Brain, head of fixed income at Newton Investment Management there are two strategies in particular that can offer yield to investors at the moment – multi-asset credit and Asian bonds. 

 

Investors are buying multi-asset credit as well as instruments like high yield bonds, and “there are good reasons why they should continue to do well”, says Brain; MACs can offer a higher income, as well as diversification, although he admits that some of the underlying assets are more prone to credit cycles and defaults. 

As such, they should be a relatively minor part of a bond allocation, leaving room for government bonds to be held as an insurance policy. However, their flexibility and diversification also mean they are never fully exposed to a single segment of the bond market. 

 

 

Another area that could be attractive to bond investors looking for higher returns is emerging Asia. The different interest rate paths compared with Europe or Japan, as well as the currency element, mean investing in this region “gives us a chance to add value", Brain says. 

 

 

Among emerging markets, Asia stands out because of countries’ relatively high credit quality. For sovereign bonds this has been improving because of long-standing surpluses and positive economic growth. 

“Any country with an improving credit rating is more likely to pay its bills. You can't say the same about Latin America or Africa,” observes Brain. In addition, real rates in countries like China, Malaysia and Indonesia are higher both in an historical context and compared with other emerging markets, leaving scope for monetary easing. 

 

And while Asian countries are still part of the emerging market universe, this can change. Unlike other regions, countries in Asia are in the real sense still emerging, says Brain, and could therefore join developed nations in the not too distant future. 

 

 

Climate risk is high up on the UK government’s agenda, and pension funds are subject to a swathe of new disclosure regulations – with more to come – and are also under greater pressure to exert their stewardship rights. But how do ESG and stewardship fit into a world where defined benefit pension funds are less likely to be shareholders of companies, and more likely to be buying their debt? 

 

Brain does not see a contradiction between fixed income and ESG and stewardship. As a bond investor, he says the governance part has always been important in looking at issuers because poorly governed companies and countries are more likely to default. Over the past three years, there has in addition been “a very strong trend” indicating that environmental analysis equally helps to identify differences in performance, he says. 

 

Pressure from investors has also grown in that time. “We get asked all the time about our ESG processes,” says Brain, and ever more often, investors ask for data of the portfolio, such as the carbon footprint. Carbon metrics might not be as accurate and pure as some other metrics, but they are “getting better and better”, he notes. 

 

ESG frequently requires engagement with investee firms, something that is often believed to mean shareholder voting. However, as bondholders of high yielding, small companies that do not issue shares, investors can have a lot of influence, argues Brain, noting that as an ESG-integrated house, Newton is regularly engaging with underlying companies on ESG matters.  

 

For example, the firm has engaged with family-owned food retailer Iceland this year over the impact of Covid-19 on future sustainability initiatives, and also its product labelling. With Balfour Beatty, the owners of offshore wind farm  Gwynt Y Môr OFTO, the asset manager discussed ESG and cyber security risks among others. 

 

These are just some examples, but Brain says generally investee firms “need to keep us on side, they need to listen to our opinion. If we find that a company has a bad ESG score, we’ll point that out to them.”