Home > Insights > Investment Strategies > The Case for Long UK and U.S. Credit for UK Pension Schemes​

Long credit bonds have the potential to help UK pension schemes improve yields, diversify exposure to equities and gilts and maintain a duration matched to liabilities. Valuations are attractive, fundamentals are stable, technicals are improving and interest rate risk can be hedged. Portfolio Managers Mike Amey, Mohit Mittal and Ketish Pothalingam and Head of the EMEA Client Solutions Jeroen van Bezooijen elaborate in the following interview.

Q: UK pension schemes have gone through a long cycle of de-risking. Over the past 20 years, equity allocations have fallen from close to 80% to roughly 40%, while fixed income has increased from around 15% to close to 50%1. Will this trend continue?

A:We see continued desire to reduce risk, but two factors make this hard: low funding levels and expensive matching assets. The aggregate funding level of UK pension schemes was 85% at the end of 2015, close to the lows of just under 80% seen in 2012 and early 2015, according to the PPF 7800 index2 .

At the same time, index-linked gilts, the natural matching assets for inflation-indexed UK pension liabilities, are expensive, as discussed in our September 2015 Viewpoint, “Navigating Divergent Global ILB Markets: Why Are UK Index‑Linked Gilts Persistently Overvalued?”. The real yield on 30-year index-linked gilts is currently around -0.8%. This is near historical lows and expensive relative to nominal gilts with long-dated breakeven inflation levels of around 3.3% (defined as the difference between the yield on nominal and index-linked gilts of the same maturity). This is materially higher than the 2015 retail price index (RPI) inflation of 1.2% and the Bank of England’s implied RPI inflation target of about 2.7% (consumer price index (CPI) inflation target of 2% plus about a 0.7% RPI-CPI wedge).

Q: How does investing in long credit help?

A: Investing in long credit can help pension schemes improve their risk/return profile (i.e., information ratio). It can potentially improve yields, diversify away from equities and gilts and maintain a duration matched to liabilities. We estimate the average UK pension scheme may realize a return of 1.5 percentage points over gilts over the long term, based on current asset allocations. We estimate this could increase to 1.8 percentage points over gilts, if 20% of the allocation were shifted from index-linked and nominal gilts to long UK credit3. This would increase risk (as measured by funding-level volatility or surplus-at-risk) by only a modest amount, therefore improving the risk/return profile.

We believe long credit is attractive, with the BofA Merrill Lynch 10+ Year Sterling Corporate Index and the BofA Merrill Lynch 10+ Year U.S. Corporate Index yielding 4% and 5.1%, respectively, as of 29 December 2016. UK long credit is attractive as it is benefiting from the UK cyclical recovery and reduced corporate supply, which we believe will continue in 2016. Valuations have also become more attractive with spreads to gilts back to 2012 levels and comfortably above their pre-2008 levels (see Figure 1). We discussed the benefits of long UK credit in our September 2015 Viewpoint “Is It Time for UK Pension Funds to Increase Holdings of Long-Dated Sterling Credit?”

For pension schemes that can invest outside of the sterling denominated bond market, U.S. long credit is also an attractive alternative. The economic expansion in the U.S. should continue to support a low default environment outside of higher risk credits in commodity-related sectors; spreads have widened even more than UK long credit (see Figure 1).
 



Q: Why is long U.S. credit attractive for UK pension schemes?

A: We find U.S. long credit attractive in both an absolute sense as well as specifically for UK pension schemes. Valuations are attractive, U.S. corporate fundamentals are stable and technicals are improving:

• Valuations: Current spreads are close to the widest they’ve been in 20 years (aside from the 2008 financial crisis), as shown in Figure 1.

• Fundamentals: We expect real U.S. growth of 2% to 2.5% in 2016. While we believe the U.S. Federal Reserve will continue to hike interest rates, monetary policy is likely to remain accommodative, with real rates staying negative for a while. Historically, credit has done well in similar contexts. Additionally, corporate leverage has picked up modestly but remains in line with long-term averages.

• Technicals: We have seen a heavy supply of corporate bonds in the last couple of years, partly driven by M&A activity and the desire to fund ahead of the Fed hikes. Additionally, low absolute yields and expectations of Fed hikes have kept U.S. pension investors sidelined. As rates increase, we expect the balance to shift – from high supply and low demand to low supply and higher demand – thereby supporting credit spreads.

The U.S. long credit market is also large and well diversified as Figure 2 shows.
 


 

The currency risk embedded in long U.S. credit can be hedged with currency forwards, in the same way as investors typically do with a global investment grade credit portfolio.

Q: UK pension liabilities are mainly inflation-linked, so how good a match can nominal corporate bonds be?

A:While the majority of UK pension benefits are inflation indexed, they typically are subject to a cap of 2.5%, 3% or 5%. This is known as Limited Price Indexation, or LPI. If inflation rises above this cap, pensions are, in effect, nominal. Therefore, if the difference between the yields on nominal bonds and index-linked gilts is close to this cap, pension schemes could be better off buying nominal corporate bonds instead of index-linked gilts. 

Figure 3 shows that yields on long UK corporate bonds and long-dated index-linked gilts4 differed by that amount at the end of January. For long U.S. corporate bonds, the difference was close to six percentage points. So, if inflation stays below the cap, long credit would likely provide a higher yield and return over time than index-linked gilts, assuming defaults and downgrade losses are kept to a minimum. If inflation rises above the indexation cap, index-linked gilts would likely perform better – but this is not required to match the liabilities because pension schemes do not need to index pensions beyond the cap.
 


 

Q: How good a liability hedge is long U.S. credit? The currency risk can be hedged, but that still leaves a portfolio of bonds whose value is tied to the U.S. yield curve, while pension liabilities are based on the sterling curve.

A:Currency is the main risk. Over the past 20 years the volatility of the USD-GBP exchange rate has been almost double the mismatch risk between the long end of the UK and U.S. curves. So it is more important to hedge the currency than the interest rate risk. We believe that for an average UK pension scheme that invests 30%-40% in equities and matches about a third to half of liability interest rate and inflation risk, the U.S.-UK curve mismatch would not add materially to total risk. For example, if we switch into long credit but move into (currency-hedged) long U.S. rather than long UK credit, we estimate, based on PIMCO’s risk factor models, that surplus-at-risk only increases modestly by 0.2% to 0.3% (of liabilities). This is because the correlation between the yields on long UK and U.S. credit is 70%-90%5.

In addition, the UK and the U.S. have followed a very similar interest rate cycle over the last few years, a trend we expect to continue over the foreseeable future given that the two economies are experiencing synchronous cycles with rising employment and wages, likely leading to rising policy rates in both countries over the next 18 months.

However, the duration can be swapped to sterling, if required, through cross currency swaps that pay away U.S. duration and receive UK duration. This reduces the yield of a long U.S. credit portfolio by about 0.4 percentage points to 4.7%, which is still higher than the 4% yield on long UK credit. The largest part (0.3 percentage points) of the yield reduction is due to long-dated UK swap rates being lower than long U.S. swap rates. In addition, there is about a 0.1 percentage point cross currency basis that investors will pay away. That reduces the spread on long U.S. credit from 2.7% to 2.6%.

Q: Is now the right time to buy long-dated credit, given that we are at the start of a rate hiking cycle?

A:We expect the Fed to continue increasing interest rates in 2016 and the Bank of England to follow suit later in 2016 or in 2017. However, we do not expect a significant sell-off in long-dated yields because the market has already priced in a rate hike cycle. In addition, our New Neutral thesis holds that increases will be gradual and the endpoint lower than in previous cycles.

Nonetheless, even if yields move higher than predicted, we expect credit yields would rise by less than government yields because credit spreads tend to tighten in such scenarios. In other words, long gilts would suffer more than long credit.

For pension schemes still concerned about the risk of rising rates, we believe it makes sense to buy long credit, while also hedging interest rate risk through swap overlays. They would then own the bonds and earn the spread but not suffer price losses when interest rates go up. When they feel yields are more attractive, they can simply add back the duration by taking off the swaps.

Overall, we believe that long credit today, both UK and U.S., offers good value to pension schemes that are either seeking to get more from their matching portfolio or seeking to de-risk some of their equity holdings. However, active credit selection and monitoring are key as dispersion within credit markets has grown; the difference in total return between the best- and worst-performing sectors exceeded 20 percentage points last year. Market volatility around rate hikes should provide attractive entry points for investors in the long credit markets. Nonetheless, independent analysis and active management will be more important than ever to fully capture the opportunity.

1 Source: Pension and Lifetime Savings Association (PLSA, formerly National Association of Pension Funds, NAPF), Mercer
2 Source: Pension Protection Fund (PPF)
3 Based on PIMCO’s 10-year Capital Market Assumptions as of April 2015
4 Represented by the BofA Merrill Lynch 10+ Year UK Gilt Inflation-Linked Index (G9LI)
5 Over the period 1996-2015, based on monthly BofA Merrill Lynch index data)

The Author

Mohit Mittal

Portfolio Manager, Multi-Sector

Jeroen van Bezooijen

Product Manager, EMEA Client Solutions and Analytics

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