Time to increase holdings of long-dated sterling credit

The search for yield turns towards gilt and sterling-denominated investment-grade bond yields

Ketish Pothalingam and Jeroen van Bezooijen

In a world of low yields, low returns and low inflation (PDF) pension funds looking to de-risk portfolios may feel the room for manoeuvre is limited. If pension funds are thought of 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. Long-dated fixed income could serve as a natural candidate for matching pension funds’ long-dated liabilities.

LOWER GILT YIELDS, HIGHER SPREADS

Yields on UK gilts have fallen over the past 12 months, reaching all-time lows following the Brexit vote, but spreads on investment grade bonds have increased and remain at levels above those seen prior to the global financial crisis. Along the risk spectrum, long-dated investment-grade credit could offer pension funds an attractive middle ground between gilts and equities. Long-dated investment-grade credit looks attractively priced versus the broad UK credit market, supply and demand technicals are supportive and corporate fundamentals appear in good shape.

As such, this asset class may offer good value to pension funds either looking to match more of their liabilities or seeking to de-risk some 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 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 4.5% to 5% more than index-linked gilts, as they do at the moment, 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. Even if inflation rises above 5%, all liability increases are capped at 5% or lower, meaning the fixed-interest bonds still offer a good hedge.

Provided an investment manager has the credit research capabilities to steer clear of credit defaults and react appropriately to credit downgrades, our analysis indicates that there are only a few scenarios where UK index-linked gilts represent a less expensive hedge option than long-dated UK corporates.

Against the prospect of rising rates, investors may be concerned about the higher duration of long-dated credit. However, in the aftermath of Brexit, we expect the Bank of England (BoE) to lower interest rates from 0.5% towards 0%, and, if required, to resume quantitative easing. We do not see any chance of rate hikes in the foreseeable future because the BoE will be more focussed on avoiding a sharp economic downturn. We believe the BoE will take a more benign view on inflation, even though sterling’s fall will put some upward pressure on prices. Over the longer term, our outlook is for the neutral policy rate for the UK to be lower than in past cycles, at around 2% to 2.5%. Of course, for UK pension funds looking to match liabilities, rising rates are less of a concern, as higher yields reduce both asset and liability valuations.

OPPORTUNITIES IN THE STERLING MARKET

The relative performance of long-dated credit versus all-maturity credit, in terms of both the spread over government bonds and the yield-to-maturity over the past decade, suggests that a move into long-dated credit has merit. Furthermore, supply and demand technicals are also supportive. After the changes made to UK pension regulations in the 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%. We think this dynamic is supportive for the sterling-denominated investment-grade credit market as the sharp increase seen in US-based issuers issuing in euros has not been replicated in the sterling market.

Finally, corporate fundamentals also remain healthy. Across measures such as leverage, mergers and acquisitions activity, and balance sheet strength, corporations in this current economic cycle have in general remained conscious of the need to maintain solid credit metrics. This means leverage remains at long-term averages. In the financial sector, new post-financial crisis regulatory pressures continue to exert a strong influence on issuers to decrease leverage and increase capital. This in turn continues to make financials an attractive sector for credit investors.

These developments suggest that it may be an optimal time for UK pension funds to add to their current long-dated sterling credit holdings.

Time to increase holdings of long-dated sterling credit

The search for yield turns towards gilt and sterling-denominated investment-grade bond yields

Ketish Pothalingam and Jeroen van Bezooijen

Time to increase holdings of long-dated sterling credit

The search for yield turns towards gilt and sterling-denominated investment-grade bond yields

Ketish Pothalingam and Jeroen van Bezooijen

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