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A
view to make a killing
Bonds
are a steadily growing asset class set to make a killing. Shifa
Rahman asks why are they doing so well?
Baby
bonds are the latest offering from the Labour camp and set up the
theme for corporate bonds precisely. It is all a question of guarantees.
The government hopes to set up guarantees for the future of our
children and similarly, the fixed income market ensures that guarantees
are there to meet pension liabilities – the money which pension
funds promise to pay out.
An even better analogy is perhaps a loan or mortgage. Holding equities
is like being the owner of a property, where the value of a house
is crucial to the investor. Holding bonds on the other hand, is
similar to being a mortgage lender, as you will be receiving income
over a time, regardless of capital value.
The FRS 17 accounting standard, set to come into force in 2002,
states that corporate bonds can be used to work out the value of
pension funds by matching the value of pension assets with its inflation
linked liabilities. This is particularly useful for larger companies
such as British Steel, where the size of its accounts are far larger
than its business. Bonds therefore enable a low-risk element in
portfolios and so reduce volatility.
It may be significant that corporate bonds are currently doing so
well. The question is why at the moment would corporate bonds be
a good choice for the government?
The bond market is rising steadily and is for the first time outperforming
equities. There has been a consistent demand due to several factors
such as reducing government bond market yields. As the government's
grip on inflation tightens, the current issuance of gilts has been
historically lower, hence the currently low annuity rates. The Government
has less of a requirement to borrow money, and so this reduces the
requirement to issue debt and thus pushes down the gilt supply.
Accordingly, many have looked to institutional demand for bonds
and international bonds as an alternative supply.
Another reason for an increase in bonds is that we have suffered
the worst fall in stock prices ever since the depression in the
1930s. With growing maturity of pension funds as a result of increased
mortality rates, there has also been more interest in fixed income.
One is that the currency risk within the Euro area has been removed
which will lead to an increase in institutional investment, especially
in light of the wilting government bond supply. A report International
bonds and the draft directive on taxation of savings by the Treasury,
also states that it is likely that non-Euro investors will give
greater euro weighting in their portfolios because of the reduced
cost of holding and hedging, as one currency will effectively replace
eleven.
James Foster, director, credit research and strategy at Royal &
SunAlliance speaks about the impact of change in the bond market:
"There will be gradual process of a transformation in pension
funds over the next few years. FRS 17 will have a positive impact
on the uptake of bonds but the abolishment of MFR and will be largely
irrelevant.”
With the abolishment of the Minimum Funding Requirement (MFR), corporate
bonds are fast becoming associated with a broadening of the investor
base with the aim of adding additional yield to a pensions portfolio.
The extent to which fund managers will switch from one asset class
– gilts, to another – bonds, however is arguable. Most
point to FRS 17 as having a far greater impact on the bond market,
as it attempts to reduce balance sheet volatility.
According
to Andrew Wickham, associate director of sterling fixed income at
Schroders: “From the perspective of pension funds there will
be a switch from government bond mandates to corporate bonds.”
He adds: “As the pension fund matures the exposure to equities
will decrease with an increase in the exposure to bonds. With more
people currently retiring due to increased mortality rates, there
is a greater demand for corporate bonds. It is natural first step
for pension funds seeking to increase returns whilst continuing
to match pension liabilities.” As corporate bonds are considered
to be low-risk, they are appropriate for providing guaranteed returns
in the mature stages of a pension fund.
Wickham also examines the relative size of the two markets. “According
to the Caps survey, there was an increase in the asset split between
the two classes, with 12 per cent of the bond exposure being corporate
bonds, which was greater than government bonds for the first time
this year. It has exceeded government bonds worth £300 billion,”
says Wickham.
The WM, All Funds Universe, measuring 75 per cent of all pension
funds, shows that £290 billion is spent on UK equities, £139
billion on overseas UK bonds, and £60 billion on UK corporate
bonds and £24 billion for overseas corporate bonds. As an
overview of the whole market, it has been estimated there has been
rise in sterling non-gilt issuance which has risen from £60
billion in 1997, which by 1999 grew to £284 billion.
Traditionally, the corporate bond market has been a non-growth sector,
because of risk factors associated with it. The 46th edition of
the Barclays Equity Gilt study, shows that: “At the end of
2000, the Barclays Capital Sterling Bond Index consisted of 53.5
per cent gilts and 46.5 per cent non-gilts”. It predicts that:
“At some point during 2001 there will be more non-gilt fixed
income in the market than gilts.”
The study is based on an annual report which includes data and analysis
of the US and UK equity market, bonds and government bonds. This
is a dramatic change from last year, which measured that the total
return from equities was -8.6 per cent, after adjusting for inflation,
sharply underperforming gilts, which returned 6.1 per cent in real
terms.The report states: “The last three years have been characterised
by extreme swings in relative performance.” Last year’s
14.7 per cent underperformance by equities, the 9th worst in our
101 year history. This bizarrely followed 1999’s outperformance,
coming after 1998’s big shortfall.
The recent study indicates that corporate bond spreads are in excess
of levels required to compensate investors for default probability.
It adds: “This suggests a further period of outperformance
or a discount for a significant increase investment grade defaults
far above the rates seen in the last eighty years”.
The study shows that the equities underperformed bonds by 30.4 per
cent during the course of 2000, which was the widest margin of underperformance
since the 1930s. The only periods where equity underperformance
has been of a similar magnitude was in 1930, 1931 and 1937. Historically,
corporate bonds have underperformed relative to gilts. Last year’s
figures show that in June, bonds returned at -0.9 per cent and overseas
bonds at -2.1 per cent.
However there has been a pattern where the corporate bond market
have shown relative lower volatility. By 1999 sterling non-gilt
issuance had nearly trebled to £171 billion, with the broad
fixed interest market climbing to £407 billion.
Many have looked to Europe as an indicator of why corporate bonds
have steadily grown. Increased issuance in Europe has encouraged
investors to include corporate bonds in their portfolio. As statistically
more companies are taking a more global approach on raising debt,
more companies have been issuing bonds in dollars and Euros.
With new European converging markets such as Poland, Hungary and
the Czech Republic and the prospect of additional countries joining
all the time, fund managers will be forced to trade with three of
the world’s major currencies, the dollar, yen and euro.
So what if any are the risks to pension funds? The main problem
with guaranteed products is that they are inflexible. Early surrender
almost certainly means a loss of capital.
As the potential return is fixed at the outset, you are likely to
miss out on any large gains in the stock markets or an increase
in the interest rates. At the moment, however a fixed return during
a period when interest rates are declining, plus the protection
against highly volatile share prices makes them an extremely attractive
proposition.
PricewaterhouseCoopers has conducted a survey which shows that 75
per cent of pension funds show a change in investment strategy as
a result of recent changes. Most found that holdings in fixed interest
securities will need to increase.
In an era of low inflation and an historic fall in the equity market,
corporate bonds are emerging as a distinct asset class and will
increase in importance. With the element of risk in pension portfolios
increasing an investigation into alternative investments is required.
–
Pensions Age June 2001–
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