The U.S. corporate bond market is expected to become a pool for U.K. pension funds to fish in as they begin to move further into using physical assets for hedging tools within their liability-driven investment programs.
U.K. LDI programs frequently use derivatives in the form of interest-rate and inflation swaps, to hedge their liabilities. But the pricing of these swaps has increased and supply has waned, particularly since the summer, pushing pension fund executives to find other hedging tools.
Sources in the money management industry highlighted the depth of the U.S. corporate bond market in particular as a draw.
The annual level of supply of corporate bonds in the U.S., at $1.2 trillion, is more than twice the size of the entire U.K. corporate bond market, said sources.
“We are seeing U.K. pension schemes using U.S. corporate bonds and hedging back” the currency, said Ritesh Bamania, principal at Mercer Ltd. in London. “From a value and risk management perspective, a global (exposure) is likely to be better than a U.K.-only focus.”
Robert Gall, head of market strategy at Insight Investment in London, expects the use of corporate bonds to evolve. “But if U.K. schemes want to own long-duration assets, the U.S. is clearly the place to look — there is a much broader universe of them there.”
But even the use of U.S. corporate bonds would still involve the use of derivatives. “You do not completely escape derivatives, as you have to swap interest-rate and currency risk out of the program,” said Mr. Gall.
There are other options and assets that U.K. pension funds are increasingly seeking out to hedge their liabilities. “Pension schemes are looking for hedging exposures that are long-dated, and in most cases inflation-linked,” said Ross Pritchard, London-based head of LDI solutions management at Schroders PLC. “To do that, they want something with a pretty solid, predictable cash flow stream, and a solid asset behind it. For example, infrastructure lends itself to this — it is in natural harmony with what a pension scheme might be trying to do.”
Mr. Pritchard said there is also increasing focus on using credit “in most of its forms as part of or alongside LDI strategies.”
Craig Gillespie, partner at Aon Hewitt in London, said infrastructure is being used as part of the hedging program, “but that tends to be a small number of clients. The issue is that the yield tends not to move exactly in line with swaps and gilt rates used by the (pension fund's) actuary or insurance company to value those liabilities.”
He said infrastructure tends to be more of a “return play, and tends to be those clients there for the long haul.”
Mr. Bamania also highlighted senior infrastructure debt and ground rent, which tend to be inflation-linked, as “secure and stable cash flow assets. But supply is low, and interest rate sensitivity — which is what LDI is based on — isn't great. But it does help to meet cash flows over the next 10 to 20 years.”
With these assets, Mercer will look to tweak LDI to accommodate that, suggesting to clients that they reduce interest rate risk 90%, rather than 100%, “and accept that you always have 10% risk on the table, but have quasi-matching assets which benefit you and help to reduce leverage” in the portfolio, he said.
“The objective has been to move to the annuity-style provider type model — buy corporate bonds, build a cash flow (matching) portfolio that pays the bills over the next 15 to 20 years,” said Rupert Brindley, London-based managing director, global pension solutions and advisory group, at J.P. Morgan Asset Management. “That is why the focus of attention in the U.K. is moving more toward corporate bonds, credit, infrastructure and private markets, rather than derivatives that continue to evolve and are expensive.”
