Ijeoma Ndukwe explores the optimal bond allocation strategies for pension funds in the current low interest environment

The promise of a stable, secure and low risk asset are part of the appeal held by bonds. However, the increasing difficulty of generating attractive yield for pension funds in a low interest environment is a significant challenge for investors. One may argue that pension funds place more emphasis on risks rather than returns and the need to reassess what is a risky asset, in light of the Eurozone crisis, should be at the forefront of their bond allocation strategy. Given the current climate plagued with market volatility, low confidence levels and the economic plight of governments in developed nations, there is a need to invest in safe assets. Despite this, it has become clear that pension funds must broaden their investment universe, not just by increasing credit in the portfolio, but also adding new bonds such as high yield, emerging market debt and convertible bonds.

Many investors say they are seeing a real focus shift in bond allocation, with specialists identifying emerging market debt (EMD) as a rising star among the debris of the financial crisis. J.P. Morgan Asset Management European head Paul Sweeting attributes its allure to the fact that over half are investment grade. In addition, it is backed by economies which are strengthening. He says: "It's starting to look increasingly secure compared with traditional developed markets bond investments. And of course it still offers a very attractive yield." Sweeting explains: "Investment grade emerging market debt yields around 200 basis points over high quality developed market government bonds."

Allocations to EMD are growing as pension funds realise that emerging markets are improving while the developed market is deteriorating. State Street Global Advisors (SSGA) Head of EMEA product engineering Niall O'Leary says that on the "return-seeking" element of a portfolio he has seen increased allocations to corporate bonds in recent years, and with the more advanced funds, allocations to both high yield and emerging market debt. O'Leary says: "These trends are likely to continue as schemes seek to diversify the risk premia they target in order to improve the overall efficiency of their portfolio. Indeed many emerging market economies have far healthier debt metrics than some of the developed economies, particularly those on the periphery of the Eurozone."

The Eurozone crisis has affected confidence in allocating to the peripheral nations Portugal, Ireland, Italy, Greece and Spain (PIIGS). Fischer Francis Trees & Watts (FFTW) global products investment specialist Michael Victoros says the impact of the Eurozone crisis has had a varying effect from country to country, but he has noticed an interesting trend in Germany. "Some pension funds [in the country], following the peripheral crisis, asked for proposals that excluded or reduced peripheral countries from the index, but included emerging market countries."

Victoros says he is seeing pension funds increase their allocation to EMD, which is currently only around five per cent of Global Aggregate indices, although emerging market countries make up 34 per cent of global GDP. However, he has also noted that a more tactical rather than strategic approach is being employed with pension funds maintaining their allocation on corporate bonds, but with a quite a wide spread.

Furthermore, in a diversified portfolio sovereign bonds are still proving a secure investment given the volatility of equities for example. M&G head of institutional distribution Bernard Abrahamsen says: "The sharpest focus is on government debt at the moment. However, most UK pension schemes, with sterling liabilities, will have most if not all of their sovereign bond allocation in the UK. In fact the UK 30 year gilt has been the hero of the crisis. In the last five years its yield has barely strayed outside a 4-4.5 per cent range, even when the financial system seemed on the verge of collapse."

DB Advisors fixed income portfolio manager Gordon Ross confirms that the core gilt market continues to be a prominent focus for pension funds. Furthermore, corporate bonds which have an issue of low supply do not have the issue of low yield. "With the current volatility in the equity market, corporate bond spreads are offering attractive yields in the long end," says Ross.

There is gradually more emphasis on de-risking, which is being approached in a number of ways including a shift in thinking on currency exposure. Victoros states: "We are seeing more pension plans pay more attention to their currency risk exposure, and better managing this, by either reducing currency risk exposure by hedging back to their base currency, or actively allocating risk to currency alpha strategies." He explains: "This is as a result of the 2008 crisis, when markets saw currency volatility peak, and un-managed currency exposure could have had a large influence on returns on a global bond mandate."

Redington co-CEO Robert Gardner says that the big question for many pension schemes in the UK is how much sterling interest rate and inflation matching they have against their liabilities. He explains that inflation protection can be bought at quite attractive levels at the moment with interest and inflation risk managed through swaps, inflation swaps, gilt repo and gilt total return swaps.

Gardner says: "Pension funds that have a serious shortfall for inflation can buy that shortfall at attractive levels right now. The key thing is that the more sophisticated funds can look at this and there is the ability with the use of derivatives and the use of swaps to intelligently pick up the characteristics of the bond universe that match their requirements. That gives them a serious competitive advantage to those that aren't able to do that."

O'Leary emphasises the need for schemes to de-risk by ensuring that the assets of the fund more closely reflect the liabilities. "In this regard, there is a continued shift out of risky assets such as equities and into matching assets, i.e. assets that more closely resemble the liabilities of the scheme, such as nominal and inflation linked bonds or strategies involving swaps."

He continues: "One of the challenges here is that highly rated government bonds are currently perceived as very expensive, with yields at or near record lows, and as a consequence, many pension schemes are reluctant to shift out of equities and into bonds at this time."

Despite this, Sweeting urges investors to adopt a long-term approach. He says: "I think the overall message should be that you don't want to base your decision on your fixed income allocation based on current yields, but on a longer term strategic plan."

Institutional pension fund clients are increasingly more focussed on the index according to Victoros. O'Leary agrees that there is currently a discussion on the future of the index: "Investors are questioning the traditional market cap weighted indices used for government bonds and favouring the development of GDP weighted indices or ones which use other fundamental measures."

Although the impact on bond allocation in light of the US credit downgrade is yet to be seen, some say that it has added to risk aversion on the market. The downgrading was evidently more stress for equities than fixed income and investors are continuing to buy US treasuries as an asset. Henderson Global Investors co-head of global institutional business Nick Adams explains: "US Treasuries have performed strongly since the S&P announcement as they continue to be a safe haven given the troubles in the global economy at the current time. Should another rating agency downgrade US debt then we might see a more pronounced effect."

According to Gardner, some pension funds are looking at alternatives to bond or fixed income investment and are looking for assets which are bond-like in nature. He says that hard assets such as real estate and social housing with a long-dated lease as well as infrastructure assets are increasingly attractive. However, there are a number of opportunities within the bond universe particularly on the credit side. Investing in credit assets such as asset backed securities (ABS), commercial mortgage backed securities (CMBS), senior banked loans and high yield all provide opportunities for high return.

Abrahamsen advises: "If anything, pension funds shouldn't get distracted by all this short term noise. They are de-risking in any case, moving from equities to bonds, so that removes a lot of market volatility and they should also remain focussed on their long term risks from interest rates and inflation."

Written by Ijeoma Ndukwe, a freelance journalist

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