Investors hit fixed income at its core

Institutional investors' overhaul of their fixed-income portfolios amid ever-lower interest rates and quantitative easing has fueled an exodus out of core fixed income into areas of specialization — particularly emerging markets, high yield and private debt.

Experts suggest that trend will continue over the next five to 10 years as market uncertainties such as the European debt crisis subside and the developed world works through deleveraging so economies eventually return to stronger growth.

Last week, the European Central Bank cut interest rates to a record low 0.75%, while the Bank of England announced a further £50 billion of quantitative easing. In June, the Federal Reserve extended its Operation Twist program to the end of 2012 after stating in April that interest rates would be near zero for at least two more years.

Government debt issued by the U.S., the U.K., Germany and others have been havens for investors buffeted by volatility in other asset classes, although the flight to quality bonds has driven down yields on these safe assets.

“We have seen acceptance (among clients globally) of the need to work bonds harder, something we have been pushing for a while. This has manifested itself in more global credit, more emerging markets debt, and generally mandates where there is a good prospect of boosting returns from active management; the casualty of this has been the narrow government bond mandate where we have seen very, very few plain-vanilla searches,” Ed Britton, London-based global head, fixed-income manager research, at Towers Watson & Co., said in an e-mail.

Across its global client base, Towers Watson conducted three U.K. bond searches in 2011, down from 28 in 2007, while emerging markets debt searches numbered 46 in 2011, up from zero in 2007.

Although other factors are in play, rock-bottom interest rates and falling yields on the safest bonds have pushed investors to search for better bond returns, added Thomas Brooke-Smith, investment consultant in Towers Watson's asset research team in London. The 10-year median real return assumption on U.K. gilts is now -1%, down from 1.6% in 2007. That's affected all spread strategies; however, the credit risk premium has risen since the global economic crisis. “We would think of credit assets as being more attractive on a relative basis at the moment,” Mr. Brooke-Smith said.

In fact, PricewaterhouseCoopers LLP estimates U.K. corporate plans could add a total of £20 billion ($31.3 billion) in investment returns by moving out of U.K. government bonds and into highly rated corporate debt.

“With another round of quantitative easing announced, sponsors and pension trustees need to ask themselves whether holding gilts is still the best option, depending on their attitude to risk and return,” Raj Mody, partner and head of pensions at PwC, London, said in a news release.

While U.S. Treasuries have been similarly affected by low interest rates, quantitative easing and a flight to quality, U.S. pension funds aren't as likely to be able to benefit from a move to high-grade corporate bonds for the simple reason that many of them already have done so, Nick Secrett, director at PwC in London, said in an interview.

“There's much more confidence in the corporate bond market in the U.S. than there is in the U.K.,” in part because the U.S. market is much larger and more diverse, Mr. Secrett said. While U.S. investors might benefit from moves into other areas, such as emerging markets or private debt, “you probably can't argue they fall into the same (liability) matching category,” he said.

European institutional investors have become more concerned about low interest rates impeding their ability to reach their return targets, according to the semiannual RiskMonitor report by Allianz Global Investors based on a survey in May. Concern is especially acute in the U.K., Europe's largest pension fund market, where 18.8% of respondents rated current interest rates as a “huge risk,” up from 11.5% a year earlier, and 37.5% called it a “considerable” risk, up from 26.9%. The portion of those rating it “not a risk” fell to 3.1%, down from 19.2%.

The report also showed that European institutional investors are increasingly dealing with risks through diversification and dynamic asset allocation and less through duration management.

Paul Cavalier, principal and head of fixed-income manager research at Mercer in London, said there's an “asymmetry” in returns on duration, or interest rate risk. “You don't need to see a large rise in yields to produce a negative return” in developed markets' sovereign debt, he explained.

Richard Ford, managing director and European head of fixed income at Morgan Stanley Investment Management, London, said, “Governments are impacting prices through non-traditional forms of monetary policy, so we're taking duration risk out of portfolios and see better risk-adjusted opportunities in credit and currency risks.”

In the U.S., institutional investors have moved out of core bond strategies in favor of credit and specialist strategies since interest rates plunged following the global financial crisis, according to data supplied by Eager, Davis & Holmes LLC's Tracker Hiring Analytics. In the three years ended Dec. 31, the number of core bond hires doubled, but the value of the hires fell 28% to $29.6 billion. That's relative to the three-year period ended Dec. 31, 2008. Meanwhile, the number of credit searches rose eightfold, with their value leaping to $8.8 billion in the three post-crisis years from just $252 million in the pre-crisis period. Significant increases were also seen in bank loans, opportunistic and asset-backed strategies.

In June, the $27.8 billion Arizona State Retirement System, Phoenix, announced plans to add emerging markets debt and private debt allocations of 4% and 3%, respectively. A new asset allocation will raise high-yield bonds to 5% of total assets from 2%, while slashing core fixed income 11 percentage points to 13%.

And in April, the $6.8 billion Arizona Public Safety Personnel Retirement System, Phoenix, added a 4% target allocation to risk parity, while boosting allocations to credit opportunities, real estate, private equity and real assets, primarily at the expense of core fixed income, which was reduced by eight percentage points to 12% of total assets.

The investment committee at the $75.9 billion North Carolina Retirement Systems, Raleigh, has been considering changes to address lower expected returns in its fixed-income portfolio, according to the pension fund's Feb. 29 meeting minutes. Executives have already “more heavily weighted” the fund's $27 billion fixed-income portfolio toward corporate debt from government debt, according to the minutes.

“Although core fixed income has been the top-performing asset class over the last 10 years, the (plan) has no expectation that will continue going forward,” according to the minutes, which also noted that state bond returns are expected to fall between 2.5% and 4% over the next five years.

Members of the investment committee “noted that it would be difficult to reach the fund's overall target return of 7.25% if core fixed income, a large part of the fund's overall portfolio, only generates 2.5% to 5%,” according to the minutes.

Also, the $7 billion Michigan Municipal Employees' Retirement System, Lansing, hired Janus Capital Group to manage $500 million in active unconstrained U.S. core-plus bonds as part of a restructuring of the pension fund's $2 billion fixed-income portfolio into a core-satellite approach. The core piece is unconstrained and accompanied by a satellite piece comprising emerging markets, high-yield and infrastructure debt as well as bank loan strategies.

As investors reshape their bond portfolios in search of higher returns, bond managers added resources in key areas ahead of expected further inflows.

For example, at Prudential Fixed Income, Newark, N.J., clients have been shifting into global mandates, high yield and emerging markets, said James J. Sullivan, senior managing director and head of fixed income. Mr. Sullivan has added staff in emerging markets and has boosted its macroeconomic insights with three new economists.

Moving away from safer bond strategies into specialist areas would imply a greater portion of an investor's risk budget, and consultants said many clients have balanced bond moves by lowering risk in other parts of the overall portfolio. But some observers question whether moves out of sovereign debt indeed add risk.

Andrew Balls, managing director and head of European portfolio management at Pacific Investment Management Co. LLC, London, said that for a European investor moving out of euro sovereign debt and into global credit, “there's an argument that you've moved to (investing in issuers with) stronger balance sheets, not weaker balance sheets.”

And Brian Collett, chief investment officer of the $4.5 billion Missouri Local Government Employees Retirement System, Jefferson City, said by moving into higher-returning bond strategies, he's aiming to take advantage of the illiquidity premium.

“A lot of people demand way more liquidity out of their fixed-income allocation than they really need,” Mr. Collett said. His fund needs less than 1% of total assets each year to pay benefits. So, conservatively, he keeps 10% of assets in highly liquid fixed-income strategies, with another 15% of assets in illiquid strategies, such as direct mortgage loans. The system recently hired its first emerging markets debt manager, Stone Harbor Partners, to run $180 million in emerging markets debt.

“Illiquidity is risk, but it is risk a pension plan is very comfortable taking,” Mr. Collett said. “Our liabilities are 30 years down the road — why would we not be taking illiquidity risk?”