“The Trump-instigated trade war fears have dominated the headlines in March, creating a seesaw effect on global financial markets with equity markets plummeting and safe heaven assets, such as gilts, rallying. In the UK, the continuing demand for gilts from pension schemes and the Bank of England’s Asset Purchase Facility (APF) embarking on its £18bn reinvestment programme, were also major forces driving up gilt prices over the month.
“The sharp correction in equity markets, where the FTSE All-Share fell by over 2%, will have caused some pain to the balance sheets of many pension schemes. However, what would have really hurt was the fall in long-term gilt yields of around 20bps per annum. This is because, on average, pension schemes are still only hedging around a third of its interest rate risks, so any movements in long-term gilt yields would have three times more impact on its liabilities than the assets.”
Fund level volatility set to continue until schemes make significant changes to investment strategies
“The volatility in funding positions is nothing new or surprising. Until pension schemes make significant changes to their investment strategies, placing less reliance on equity markets and hedging much more interest rate risk, the funding level rollercoaster ride will continue. Volatility across financial markets is only likely to increase this year so pension schemes need to brace themselves for an even choppier ride.
“For pension schemes looking at the ways to achieve more consistent returns whilst protecting against severe drawdowns, there is now a range of investment products and techniques available at their disposal.
“Most pension schemes could benefit from a Cashflow Driven Investing (CDI) strategy, often labelled as an ‘insurance way of investing' by beginning to invest part or, in some instances, most of their portfolios in CDI assets to help match liability cashflows whilst generating returns in excess of gilts. This approach could provide much greater certainty of delivering the return and matching liability cashflows when compared to a ‘traditional’ approach of investing in the growth and matching assets. The CDI strategy works particularly well when combined with a Liability Driven Investing (LDI) strategy that helps manage any remaining mismatch between the assets and liabilities.
“Pension schemes are actually in a great position to ‘select against’ insurers, as they are not constrained by stringent insurance regulations that force insurers to only be able to invest in certain types of CDI assets. This means that pension schemes could achieve enhanced returns compared to insurers, for similar levels of risk taken in their CDI strategies.
“This is particularly the case when it comes to private assets such infrastructure or real estate debt. These assets have bond-like characteristics, but offer better yields with less risk than comparable publicly traded corporate bonds.
“For example, last year around £20bn was invested in high quality UK infrastructure debt assets and similar levels are expected in 2018. Due to insurance regulations, annuity portfolios invest in longer dated opportunities, typically 10 year terms or longer that meet strict investment criteria. The market in these deals is relatively small and represented around a quarter of the deals done last year. Given the continuing strong demand from insurers it has driven prices up and current yields on these over-bid deals stand at around 1.5% per annum above comparable gilts. This contrasts with a much larger market in shorter maturity deals at terms of 5 to 10 years that could yield 2.5% per annum or more above gilts.
“This is just one example where pension schemes could use their flexibility to achieve attractive risk adjusted returns. There are other opportunities in private debt and debt-like assets that could be exploited by investors that are not constrained by insurance regulations.”
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