In a world of low yields, low returns and low inflation, UK pension funds looking to de-risk their portfolios may feel their room for manoeuvre is limited. If we think about a pension fund as a stream of liabilities stretching out into the future, then matching an increasing percentage of those liabilities with fixed income assets may make sense. We view long-dated fixed income as a natural candidate for matching pension funds’ long-dated liabilities.

Why invest in long-dated investment-grade credit?

Today, gilt- and sterling-denominated investment-grade bond yields are off their lows experienced at the start of 2015 (see Figure 1), and investment-grade bond spreads to government bonds remain elevated from their pre-2008 global financial crisis levels (Figure 2). Along the risk spectrum, we see long-dated investment-grade credit as offering investors an attractive middle ground between gilts and equities. We believe that long-dated investment-grade credit is attractively priced versus the broad UK credit market; that supply and demand technicals are supportive; and that corporate fundamentals are in good shape.

 

 

In light of these trends, we believe that long-dated investment grade credit may offer good value to pension funds that are either looking to match more of their liabilities or seeking to de-risk some of their equity holdings.

At current yield levels, long-dated credit may serve as an attractive hedge for UK pension liabilities when compared with index-linked bonds. In general, index-linked bonds are seen as a natural liability hedge for pension funds because pension benefits in the UK are indexed to inflation; indexation is typically capped, and the level of the cap depends on the type of liability – for example, 2.5%, 3% or 5%. If high quality fixed-interest bonds yield about 4.5%–5% more than index-linked gilts, then these may represent a less costly liability hedge. If inflation stays below 5%, the fixed interest bonds will pay a higher yield over time. If inflation rises above 5%, all liability increases are capped at 5% or lower so that the fixed bonds still provide a good hedge.

Figure 3 shows that the difference between the yield on the Bank of America Merrill Lynch Sterling Corporate 10+ Years Index and the UK Inflation-Linked Gilt 5+ Years Index has trended closer to 5% in 2015 (it was at 4.7% at the end of July 2015). Provided an investment manager has the credit research capabilities to steer clear of credit defaults and downgrade losses, we believe there are only a few scenarios where UK linkers represent a less expensive hedge option than long-dated UK corporates.

 

What about duration risk?

Against the prospect of rising rates, investors may be concerned about the higher duration of long-dated credit. However, we believe these worries should be put into context in the current circumstances. First, rate hikes are likely to be less profound than seen in the past. Second, for UK pension funds matching liabilities, rising rates are less of a concern as higher yields reduce both asset and liability valuations.

As the global financial crisis has abated and economic growth has returned to the UK and the U.S., much of the debate in the UK has surrounded the exact timing of the Bank of England’s (BOE) next rate hiking cycle. However, the BOE has been at pains to stress that the trough-to-peak range of the next rate cycle will be less profound than previous cycles. For example, BOE Governor Mark Carney spoke on 16 July 2015 of his expectations for the peak in the UK policy rate to be “about half as high” as the long-term average of 4.5%. This is consistent with our belief that the new neutral policy rate for the UK will be around 2% to 2.5%. Another force that has tempered the BOE’s enthusiasm for rate rises has been the below-target UK inflation rate since December 2013. A combination of lower import prices, the peaking of utility bills and low wage growth has helped to keep both the UK Consumer Price Index and the Retail Price Index below the BOE’s target inflation levels. At PIMCO, we do not see a significant near-term threat from inflation in the UK.

Finding investment grade credit opportunities in the sterling market

The relative performance of long-dated credit versus all-maturity credit, both its spread over government bonds and the yield-to-maturity over the past decade, suggests that a move into long-dated credit has increasing merit (see Figure 4).

 

Next we consider the technicals, i.e., supply and demand: After the changes made to UK pension regulations in the March 2014 UK Budget, new issuance has declined in 10-year and longer-term sterling-denominated credit. From a long-term average of 53% of all issuance, longer-dated issuance has fallen to 42%.

Indeed, all sterling-denominated credit continues to lag both the euro and the U.S. dollar markets in new issuance (see Figure 5).

 

We believe the supply and demand dynamic is supportive for the sterling-denominated investment grade credit market. The sharp increase we saw in U.S.-based issuers issuing in euro has not been replicated in the sterling market.

Turning next to corporate fundamentals, i.e., leverage, mergers and acquisitions (M&A) activity and balance sheet strength, we find that in this current economic cycle corporates in general have remained conscious of the need to maintain solid credit metrics. Leverage remains at long-term averages. However, while M&A deals are returning to Europe and the UK, activity remains below 2000 and 2007 levels.

In the financial sector in particular, regulatory pressures that came into play after the global financial crisis continue to exert a strong influence on issuers to decrease leverage and increase their capital. This in turn continues to make financials an attractive sector for credit investors.

In summary, we believe that fundamentals, supply and demand technicals and valuations all suggest that now may be an optimal time for UK pension funds to add to their current long-dated sterling credit holdings.

How can investors identify the most attractive opportunities in this space?

At PIMCO, our team of over 60 credit analysts across the globe, covering both investment-grade and sub-investment-grade issuers, enables us to pursue a holistic approach to sector coverage. This in turn helps us to identify “rising stars”, companies that have good and improving credit metrics but have not yet been rewarded by the credit market with the spread levels they deserve. We also see opportunities from “fallen angels”, companies that have fallen out of the investment grade universe (in the eyes of the rating agencies) and have suffered from forced selling by investment grade investors. We believe our forward-looking analysis helps us to identify which of these fallen angels is likely to return to investment grade over time. In addition, we find that many of these companies have suffered spread widening over and above their ratings decline, and this provides attractive opportunities to invest.

Many investors have also expressed concerns over declining market liquidity in credit markets post the global financial crisis. While we believe certain market conditions, such as market depth and bid/offer spreads, have deteriorated, for long-term investors, such as UK pension funds, the decision to commit to buying long-dated credit involves several considerations. We believe long-dated credit ought to be viewed as a longer-term investment than short- and medium-term maturity bonds. At current valuations, yield-to-maturity and spread to the underlying risk-free rate, we believe long-dated credit offers UK pension funds an opportunity to match some of those liabilities with returns that offer a mid-level degree of risk (when compared with government bonds and equities). In our view, inflationary pressures in the UK will continue to remain low, and we see the path of central bank rate moves as notably shallower trough-to-peak than previous cycles and likely to remain that way. This leads us to conclude that now may be a good time for pension funds to consider adding longer-dated credit to their existing fixed income holdings.