Credit downgrades present ‘serious challenges’ for pension schemes – AXA IM

A fall in the average credit quality of fixed income indices and increased competition for high-quality assets presents “serious challenges” for pension schemes, AXA Investment Managers (IM) has warned.

Since the beginning of the Covid-19 pandemic, rating agencies have downgraded over £778bn of corporate issues across global indices, leaving high quality assets in “short supply” during a period of rising demand.

AXA IM Buy and Maintain credit team portfolio manager, Simon Baxter, stated that the concentration in high grade assets has created a testing environment for passive investors and the UK pensions sector more broadly.

“The ultra-low interest rate environment since 2015 has provided corporate treasurers with a strong incentive to increase the overall level of indebtedness in capital structures,” commented Baxter.

“This has resulted in a drop in the average credit quality of issuers, driving a large increase in the BBB component of credit indices, which now averages around 50 per cent of the main credit indices.”

Baxter noted that the credit downgrades have been insurer and sector specific, which has exacerbated the existing problem of issuer and sector concentrations, as BBB issuers have moved downward and out of IG indices and A-rated bonds have migrated to BBB.

“For the UK pension fund industry, which is particularly reliant on the higher quality, 10+ year and 15+ year A-AAA indices, this presents a serious challenge and comes at a time when there is increasing demand for high quality long-dated assets,” added Baxter.

“Plans are increasingly putting cashflow-generating solutions in place, and there are more investors chasing less available, high-quality assets. The ability to source these rare assets, at the right price, remains key to achieving portfolio goals.”

In the last two years there have been several high-profile issuers, such as General Electric, Heathrow (Class A), HSBC (subordinated) and Wells Fargo (subordinated), that have been downgraded and exited the high-quality GBP indices.

The top 10 issuers in the Sterling market now make up more than 32 per cent of the 15+ year index market value, while 50 per cent of the index is comprised of just 21 issuers – a mean issuer size of 2.4 per cent per name.

Baxter concluded: “Fixed income investors now face the possibility that EDF, the 2nd largest issuer, may lose one of its two remaining A- ratings; this would increase issuer concentrations further and leave investors reliant on an increasingly concentrated asset class.

“Those investors passively following a benchmark approach may have a very challenging and potentially costly index transition to navigate.

“A keen focus on diversification and an assessment of fundamental credit quality, as key inputs to portfolio construction, can help ensure investors are insulated from some of the negative biases of fixed income indices.”

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