Investors are reviewing fixed-income game plan

Now that Federal Reserve Chairwoman Janet Yellen has acknowledged that the central bank is likely to raise rates later this year, institutional investors are evaluating the role of fixed income in their portfolios.

Institutional investors on the whole have been reserved when it comes to their fixed-income allocations, said Bryon Willy, a principal at Mercer in Chicago.

But after 35 years in which bonds could be both a stabilizing force in portfolios and a source of return, fixed income isn't “the hedge that it historically has been,” he noted.

That change and uncertainty about exactly when and how quickly short-term and long-term rates will rise (and if they will move at the same pace) after policymakers act means there are several different responses being contemplated by asset owners and their managers. Spikes in long government bond yields in mid-2013 and earlier this year have shown what can happen quickly when changes come.

A number of money managers that Pensions & Investments spoke with said the Fed's decision earlier in September to stand pat on overnight rates, as well as Ms. Yellen's subsequent comments, have not made any significant change in institutional investors' appetite for fixed-income strategies. However, some have noticed investors gravitating toward strategies that aren't rate-sensitive, such as short-duration, unconstrained and strategic income strategies.

What rising rates will mean for institutional investors depends on the role fixed income plays in a portfolio, said Stephen M. Kane, group managing director and generalist portfolio manager in the U.S. fixed income group at TCW Group Inc., Los Angeles.

Robert C. Merton, 1997 Nobel laureate in economics and MIT Sloan School of Management distinguished professor of finance, cautioned that asset owners concerned with pension liabilities should be paying more attention to long-term, rather than short-term, rates.

“The long-term rate is the rate that matters. The implication is that if the Fed raises short rates, longer-term rates will probably go up,” said Mr. Merton. “But that doesn't necessarily mean that long-term rates will go up. They may, but they don't have to.”

For those investors that use fixed-income assets as a hedge, Mr. Kane said he believes large pension plans with a traditional 60-40 allocation plan (or something similar) shouldn't scramble to reallocate. In fact, it would make sense to keep their allocation as is.

Investors using fixed income as a source for absolute return might want to reallocate to cash before rates rise, he noted. Others hoping to generate income should shorten maturities so when rates rise, it would be easier and faster to reinvest. And those looking to implement liability-driven investing strategies should increase their allocation to fixed income as rates rise.

“It all depends on a lot of variables — including how much rates rise,” Mr. Kane said.

Other industry observers say that what happens with short-term rates might be a red herring, especially for long-term investors.

In a phone interview, Matthew Stroud, head of delegated portfolio management, Americas, at investment consulting firm Towers Watson & Co., New York, said it appeared to him that the Fed is setting up expectations for a rate increase in December, the first increase since June 2006.

“The market is currently digesting this information,” Mr. Stroud said about the telegraphed rate hike.

Regardless of what the Fed does later this year, Mr. Stroud said long-term expectations within the industry are that rates will stay low for a considerable amount of time. “Lower for longer is going to be with us for some time,” he added.

Thomas J. Marthaler, a managing director and portfolio manager and client specialist on the investment-grade fixed-income team at Neuberger Berman Group LLC, Chicago, in an interview noted that although institutional clients “still want income and to be able to manage risk,” they need to take “a different approach.”

Clients, according to Mr. Marthaler, are looking for fixed-income strategies with “less correlations to interest rate moves” and that are “less interest-rate sensitive.”

Mike Lillard, chief investment officer of Prudential Fixed Income, echoed the thought that investors increasingly are averse to strategies focused on interest rates.

“Some are concerned about interest rate risk and are going to look at things like absolute-return-like strategies that don't have duration in the benchmarks,” Mr. Lillard said. “Others, in particular (pension plans) with long-term liabilities, are thinking about extending duration, given that the yield curve is rather steep and given that corporate spreads are meaningfully wider than they've been historically.”

Mr. Lillard also told P&I in an interview conducted shortly before the Fed's announcement that although he expects the Fed to move in terms of the yield curve, it won't be able to move all that much, keeping rates “fairly low for a relatively long time.”

He believes this long-term low-rate environment makes longer-term maturities attractive and corporate and high-yield bonds more attractive than government securities.

In a separate interview after the Fed's September meeting, Robert Tipp, managing director and chief investment strategist at Prudential Fixed Income, said: “In the plan sponsor community, there's still the slow underlying current toward LDI (liability-driven investing). There's also a thought process of what return potential is still there in fixed income.”

In terms of immediate negative results from the Fed's decision, Nick Botticelli, pension risk specialist at OCIO provider Hirtle Callaghan & Co., Conshohocken, Pa., said “the immediate effect was a rally in bonds ... which caused pension liabilities to grow.”

Mr. Botticelli explained that, with the Fed's announcement, it would make sense for pension plan executives to do nothing for the time being, as they're looking for rates to rise. “So when rates do rise, they'll start looking for long-duration bonds,” he said.

Mr. Botticelli added that since Hirtle Callaghan focuses long term, the recent announcement didn't do anything to make the firm alter its bond portfolio. However, the firm is “holding more cash, being more conservative and looking for rates to rise before putting more money into bonds.”

Some asset owners that manage at least part of their fixed-income assets internally told P&I they were taking the “slow and steady” approach.

David C. Villa, chief investment officer of the $105 billion State of Wisconsin Investment Board, Madison, wrote in an e-mail that SWIB has a longer-term horizon and its strategy reflects that. “SWIB has not changed the fixed-income strategy in the past 12 months,” Mr. Villa said. “The prospects for returns are low until after the interest rate environment transitions to normal. As a result, SWIB is being defensive and not stretching for investment returns in this environment.”

Meanwhile, Bob Jacksha, CIO for the New Mexico Educational Retirement Board, Santa Fe, said in a phone conversation that the $11.4 billion plan changed its allocation a few years ago to be “less centered on core fixed income and more on opportunistic.”

Currently, the plan, which is “neutral on interest rates,” manages about $1 billion in core bonds internally and about $2 billion in opportunistic fixed income — which includes bank loans and corporate and high-yield bonds — that is run by external managers.

Mr. Jacksha said the reason for doing this was “simple math:” core fixed income wasn't giving the board the 7.75% return it was seeking. n