The recently released Myners Review of Institutional Investment examining the investment processes o...
The recently released Myners Review of Institutional Investment examining the investment processes of UK pension funds will mean wholesale changes to the UK gilt and corporate bond markets and affect those investing in fixed-interest funds.
The review recommended abolishing the minimum funding requirement (MFR), which requires pension funds to match their liabilities to pensioners with investments in low-risk, low-return gilts (UK government bonds). This, experts argue, could lead pension funds into riskier, alternative investments such as venture capital, or shares.
The Blair government hoped to encourage pension funds to move from investing about 1% of their assets in private equity, to closer to the US pension fund market, which has about 6% of its assets in venture capital.
If this occurred, the resulting move out of gilts could lead to the prices of government bonds falling. But this change may not be all bad news. People retiring who are forced to buy an annuity with a portion of their pension payment when they turn 75 might see the yield on these gilt-based products rise, according to Alisdair Buchanan, head of communications at Scottish Life.
The recent dismal returns from annuities have left many pensioners unable to fund their retirement, despite promises made to them during periods when interest rates were high and annuity returns were more healthy. The small rises in the state pension recently have left those relying on annuities to fund their retirement short of cash.
Gilt prices have been buoyed up since the MFR was introduced by the Blair government for pension funds. Prices for gilts have also risen because of the government's cutback on borrowing.
The £22.5bn windfall the Blair government coffers received last year from selling the third generation mobile phone licences further encouraged the government's Debt Management Office to trim number of gilts in circulation.
At the end of 2000, for example, the Barclays Capital Sterling Bond Index consisted of 53.5% gilts and 46.5% non-gilts, but this situation is expected to reverse at some stage in 2001, partly because of the fall in gilt issurance.
Pension funds' possible move to more volatile investment fields such as shares or even venture capital could provide policyholders with better longer-term returns. But it could also provide more volatility in the funds' portfolio.
Despite this extra volatility and risk of equities, the stock market is not guaranteed to do better than fixed-interest instruments such as bonds and gilts in the short term. Last year bonds actually outperformed equities in the UK, according to Barclays' Equity Gilt Study 2001.
"Last year the total return from equities was 8.6%, after adjusting for inflation, sharply underperforming gilts, which returned 6.1% in real terms. The last three years have been characterised by extreme swings in relative performance.
"Last year's 14.7% underperformance by equities, the ninth worst in our 101-year history [of Barclays' annual study], followed 1999's outperformance, the eighth best," Barclays' study found.
But equities have still outperformed gilts in the longer term, Barclays' study said. "Over the past 101 years the average annual excess return from equities compared to gilts has been 4.4%.
"But this has declined in recent years, and was 2.4% for the last decade."
Andrew Tunks, managing director of Royal & Sun Alliance's worldwide bonds and treasuries, said he felt the MFR had distorted pension funds' investments towards gilts, and removing it would correct this.
"We may see an allocation by pension funds away from gilts into other asset classes," said David Roberts, investment manager of Britannic Asset Management's gilt and fixed interest and high income fund.
Tunks said pension funds have had to balance their present and future liabilities to gilt investments because the movement in pension liabilities is similar to the yield on long-term gilts.
James Foster, Royal & Sun Alliance's director of credit strategy and research, said the Myners Review, undertaken by Gartmore's Paul Myners, could prompt Britain's pension funds, which together hold the largest portion of the publicly traded equity on the UK stock market, to move more heavily into bonds issued by companies, pushing up their prices.
"For a limited increase in risk they can move into corporate bonds, a trend which will probably continue this year," he said. Foster also questioned whether now was the time for pension funds to be investing more heavily in shares.
"They are going to be encouraged to raise their proportion of equities, not just into straight normal equities. But given the poor performance of equities recently this doesn't seem attractive," he said.
Trustees lack training
Another concern Paul Myners voiced was the relatively limited education about investment matters of trustees overseeing the running of British pension funds.
"At the moment trustees aren't qualified. They act more as guardians of the trust rather than guarantors. Taking on this extra risk potentially means that they are then liable for it. Inevitably these people who are not trained in the skill of liability matching suddenly end up having the government telling them to increase their fund's risk profile. I think it'll have all sorts of problems in the future," Foster said.
Roberts added that funds' asset allocation would depend upon the individual pension fund and its trustees. The general outlook within Britain's gilts market is still very good according to fund managers who still believe that if you want income, you should invest in the market because you will get a better deal than equities.
"We are very much in a low inflationary environment in the UK so against a background where there's almost no supply of gilts and there's low inflation it is difficult to get too negative on gilt markets," Roberts said.
Even so, despite last year's disappointing performance, corporate bonds are still favourable relative to gilts according to Roberts, who says it is a good time to invest in them.
"There's still reasonably good value compared with the last five or 10 years, and as far as UK corporate bonds are concerned they appear to be reasonably well insulated from the turbulence in global equity markets. Part of the reason for that is that lots of bonds in the market are old economy particularly financials and their earnings are not as cyclical as other investment opportunities around," he said.
Royal & Sun Alliance's Andrew Tunks said he expected other unrelated changes to the investment landscape, revolving around planned new accounting standards, to increase the range of corporate bonds on offer to UK fund managers and private investors.
Patrick Edwardson, fund manager at Baillie Gifford, says a lot of the volatility witnessed last year in the bond market would have already been priced into the market.
"The European economy may not be as robust in the next 12 months as it was in the last, but it seems unlikely to experience the same slowdown as the US. Even if things get worse, now could still be a good time to buy. Bond markets, like equity markets, are forward looking."
But investors should not believe that bonds are a risk-free investment, simply because large pension funds are willing to invest in them. Bond investors anticipating an economic slowdown expect bond issuers to default more on their interest payments to investors. "This is what happened in the US during its last recession and the same thinking probably shaped last year's returns," Edwardson said.
"In a similar fashion, sentiment towards corporate debt should improve before the economic figures pick up. In the US in 1990 and 1991, default rates rose to over 10%. At the same time, gross domestic product (GDP) growth hit rock bottom. Yet the same year, high yield bonds produced their best ever performance, a 39.2% return as measured by the Merrill Lynch indices.
"Investors may already have latched on to this. The first two months of this year saw high yield bonds rally strongly, while their investment grade counterparts marked time," Edwardson added.
Risk of default
One of the differences between gilts and corporate bonds is that corporate bonds are graded on the probability their issuers will default on interest payments to the bond holders. Rating agencies such as Standard & Poor's and Moody's evaluate the bond according to the perceived risk of a bond issuer not making interest payments to the bond holders.
Ratings range from AAA, which are the highest quality, to D. Bonds rated in the AAA sector tend to pay a lower rate of interest because they are seen as less risky to default.
Gilts usually have a similar or slightly lower interest rate to AAA rated corporate bonds. An example of a percentage yield from a government bond would be around 4.9% compared to 14.5% from a CCC rated company.
"Ratings agencies such as Moody's and Standard and Poor's have been credit rating bonds for some time. Drawing on their experience, an educated guess can be made at how often defaults occur at each rating band. For investment grade bonds, the answer is not often," Edwardson said.
Even for BBB-rated bonds, still seen by some investors as risky and best avoided, the incidence of default in any one year is low.
Edwardson said that despite the Federal Reserve cutting interest rates, the US economy is in worse shape now than at any point in 2000 but he doubts that corporate bond default rates will head towards 12%.
"The boom [in the US] probably encouraged an excessive degree of leverage, and the slowdown will force more companies to the wall. In Europe, though, the number of defaults so far has been minimal. Despite this, high yield spreads on this side of the Atlantic are as high, if not higher, than in the US," Edwardson said.