PENSION funds have been under tremendous pressure over the last year. Low-to-negative returns from global equity markets and negative real returns after inflation from low-risk assets such as government bonds have left many funds well short of their returns targets for the year.
At the same time as funds have suffered on the asset side of the balance sheet, the US Federal Reserve’s policy of driving down long-term interest rates has lowered the discount rate used to calculate scheme liabilities. This has had the effect of increasing liabilities at the same time as scheme assets are shrinking. Liabilities also continue to be bumped up by mortality creep (the tendency for scheme beneficiaries to live longer).
All of this has left trustees and finance directors of final salary schemes with a real need to find some way of growing returns. The alternative, namely meeting funding deficits by increasing contributions from the sponsor company, is next to impossible for many schemes in today’s extremely tight markets, where liquidity is hard to come by and cash is at a premium.
The tried and tested option for schemes looking to sweat their assets has been to increase the proportion of equities in their portfolio. However, the “risk on/risk off” behaviour that has characterised equity markets since the crash of 2008 has meant that finance directors whose schemes go down this road have to live with unduly high levels of volatility on their balance sheets, while trustees have to live with higher levels of risk than they would like – with no guarantee that those higher levels of risk will actually generate anything by way of increased returns.
Equities on the up
On the plus side, the start of 2012 has seen equities regain some of their shine. All through January markets rose, showing a marked improvement that continued into February. Markets were also surprisingly resilient to the kinds of shocks over the continuing European sovereign debt crisis, that had sent them tumbling time and again through 2011.
However, with European debt problems far from resolved there is no saying that equity markets will retain their present sangfroid in the face of further shocks, such as further downgrades of sovereigns by the ratings agencies. So going big on equities as a way of boosting returns continues to be problematic, despite the current mini bull run in the markets.
Paradoxically, a somewhat less risky strategy for schemes may well be to look at increasing their exposure to corporate debt, particularly to the high yield segment. At first sight this may sound contradictory, since high yield debt is, by definition, money lent to companies who are regarded as presenting a higher risk of default than investment grade blue chip companies. However, as Omar Saeed, head of high yield at Swisscanto, explains, the high-yield market has factors in its favour that mitigate much of the inherent risk in this asset class.
Going back five years, investors in high-yield debt would be fully compensated against the risk of default through the high interest paid on non-investment grade corporate debt, he points out. Today, investors are in the fortunate position of being able to buy high-yield debt that is fully secured against assets as well as paying upwards of 7%.
“According to ratings agencies such as Moody’s or Standard & Poor’s, even loans to asset-light companies such as retailers are seeing recovery rates of around 70% to 80%, since the loans are secured against stock and cash flow,” Saeed says.
The default recovery rate is somewhat lower in the US than it is in Europe, being around the 65% to 75% mark, since retailers there tend to be more leveraged and bankruptcy reorganisations tend to be more severe. But given very low general rates of default – and the last few years have seen some of the lowest default rates ever – the amount of interest investors are getting paid is more than enough to compensate them for the risk.
New issue premiums
Another plus point is that as the banks increasingly withdraw from providing debt finance to high-yield corporates, new companies to the market who want to tap the debt market for funding are having to pay investors a premium on top of what are already historically high rates of interest.
“We are seeing a substantial amount of new issue premiums,” Saeed says. “New companies to the debt market used to have to pay about a 10 basis point premium. That has gone up to 150 to 160 basis points. So now you are getting this premium on top of what was already an excellent rate of return, and at the same time, you are getting your debt fully secured. That is a tremendous position for investors to be in and I expect pension funds to take advantage of this situation in the months ahead.”
According to Saeed, pension funds across Europe began to recognise the benefits of an increased exposure to high yield in 2009 and 2010, both of which saw high-yield funds making excellent returns. Institutional managers have to scale in to the European high-yield market so increased exposure will take time to work through
“What we are seeing is that companies with, say, a 7% allocation to high yield are slowly moving this percentage to around 15% of their portfolio,” he says. “Those that have only a 2% allocation to high yield are scaling up to 7%, and so on.”
Colleen Denzler, head of high yield at Janus Capital, says that investors are drawing confidence from the fact that short of an outright messy breakup of the eurozone and a resulting depression, the rate of default in high-yield bonds is very unlikely to go up to any marked degree.
“High yield is one of the few investment options globally right now that offers both great returns and strong fundamentals,” she says. “Companies have built up their cash reserves and reduced their cost structures since the 2008 crash. So that is not a scenario that leads to soaring default levels.” ?
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