Protecting the yield
How can pension schemes invest for recovery amid the economic recession triggered by Covid-19?
While first and foremost a human tragedy, the Covid-19 pandemic has had a huge economic impact, plunging many nations into a deep recession after months of corporate shutdown.
Financial markets were thrown into chaos in March as governments scrambled for solutions and millions of workers were either laid off or put on furlough. Elsewhere, oil speculators may have lost their shirts for the first time in a generation.
Yet a glance at equity markets at the mid-point of the year seems to belie the still troubled state of affairs. The S&P 500 broke its all-time high in August as the pandemic raged across the US and beyond, while government bond yields in the safest nations slipped into negative territory.
This remarkable recovery does not tell the full story, however, as a drop and rebound of such magnitude must surely leave a scar – and for businesses running occupational pension funds, it is a good moment to step back and assess.
Learning from the past is a good way to prepare for the future – and 2020 has already provided plenty of lessons.
The market panic around the fallout of Covid-19 saw asset prices fall dramatically, as investors indiscriminately sold whatever they could – and it was not a sellers’ market.
With the cash they made, many scooped up government bonds – against which pension liabilities are measured – that resulted in a decline in already low yields and hit funding levels hard.
Consulting firm Mercer showed that the aggregate funding shortfall of FTSE 350 company pension schemes rose from £40bn at the end of December 2019 to £103bn by 31 July. There were similar figures released around the world.
And here is an unfortunate paradox: in the UK, while total assets rose by 3% in that period, liabilities soared by almost 10% as central banks slashed interest rates.
It was the same story elsewhere. Ultra-low interest rates are kryptonite for defined benefit pension schemes, as they both inflate liabilities and erode the yields available on fixed income assets.
However, not all bonds are issued by governments. Pension funds able to hold high yield debt, rated BBB+ or lower, could have done well out of the crisis – or at least less badly than their peers – and learning from the experience might be key for the immediate future, too.
The mass sell-off as the crisis took hold provided opportunities for nimble investors, including those prepared to scale the yield curve as others were sliding down it.
“Volatile markets have driven some of our insurance investors to reduce their risk exposure,” says Catherine Clausse, senior insurance portfolio manager in multi-asset at Amundi.
Clausse explains that investors have been making greater allocations to cash for liquidity purposes while reducing credit exposures – from high yield to lower rated investment grade – due to increased bankruptcy fears.
“These investors also reduced equity allocations, especially if not covered by option protection,” she adds.
But buying into high yield bonds and other areas of non-investment grade credit may have paid off for investors with stronger stomachs, thanks to the income they would have earned over less risky bonds.
Despite the poor performance of many government bonds, fixed income markets have generated positive returns since the start of the year, says Amundi’s Clausse.
“Central banks’ quantitative easing action has supported credit markets, through direct demand and indirect effects coming from a heightened search for yield.”
The view from Europe’s largest fund manager is that central bank support is here to stay for some time to keep financial conditions steady – and there is no doubt it has been effective.
In fact, much of the opportunity to snap up riskier assets that opened up in March and April has now evaporated.
“Public credit markets have rebounded very strongly since 23 March and recovered most of the losses incurred earlier in the year,” says Adam McMinn, fixed income portfolio manager at Mercer.
“Investment grade credit spreads are back to pre-crisis levels whilst high yield credit spreads have a little further to go.”
But if 2020 has seen stormy economic weather, pension funds need to be prepared for an extended challenging outlook.
Kate Hollis, director in Willis Towers Watson’s investments business, says bond market participants are predicting a “rise in fallen angels”, meaning companies that were previously investment grade but have since fallen out of favour could be in for a resurgence. This means there are likely to be opportunities – but pitfalls abound, too.
Hollis predicts “downgrades of many issues, both corporate and securitised, with potentially more to come, both in investment grade and high yield, which is likely to see rising defaults”.
But for those that can hold their nerve, McMinn says Mercer sees value in stressed and distressed credit opportunities, both public and private. Asset selection will be vital in these markets, given the uncertainty ahead.
Central banks can only keep propping up economies for so long, and at some point, the supports will be taken away, which could lead to a rise in defaults.
“Many struggling issuers are yet to default, and this will likely present opportunities for skilled investment managers and investors who have some tolerance for illiquidity and complexity,” he says. “Dislocated opportunities in credit markets have historically offered double-digit returns to investors. There is no reason to expect that this time will be different.”