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Roundtable: Exploring the middle ground in fixed income

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Participants

Jeremy Cunningham, investment director, Capital Group

Ed Harrold, UK institutional, Capital Group

Jeremy Randall, then-head of finance, strategy and accounting, Kingston upon Thames RBC

Karen Shackleton, director, Pensions for Purpose (chair)

Phil Triggs, then strategic finance manager – pensions and treasury, Surrey CC (now director of pensions and treasury, Triborough)

Bridget Uku, group manager – treasury and investments, Ealing LBC

Most groups of funds are working towards bringing their traditional assets into their pools first.

In an environment where falling bond yields have become the norm, investors such as Local Government Pension Scheme funds have begun to look to illiquid assets to increase their fixed income yields – but they might be missing a trick.

Speaking at an LGC roundtable supported by Capital Group, the firm’s investment director Jeremy Cunningham said: “In today’s market, everybody is trying to find some yield somewhere, and it becomes an increasingly difficult decision.”

Mr Cunningham said funds have used traditional fixed income assets to match their liabilities, but when it comes to sourcing better yields, they have turned to “real assets and infrastructure”, losing liquidity in the process.

He said there was an “overlooked” part of the market; a “middle ground” between European and US investment grade corporate bonds and illiquids: high yield corporate bonds and emerging market debt.

Mr Cunningham said there were a variety of roles for this middle ground type of asset in a fund’s portfolio: “It can play the role of yield enhancement. It also can play a role as a diversifier because it’s driven by different factors than the other parts of your fixed income allocation.”

He said emerging markets had more to offer international investors than just a few years ago.

“In the emerging markets universe, you can get corporate bonds, sovereign bonds that are denominated in US dollars, and then sovereign bonds that are denominated in the currency of the issuer. Increasingly also we’re seeing issuance of index-linked bonds,” he said.

There is also increasing diversity within high yield corporate bonds, Mr Cunningham said.

“The US high yield corporate bond market has been around for many decades and it’s the biggest market, but also Sterling and European corporate bond markets are a growing part of the focus for investors.”

Discussion chair Karen Shackleton, director of Pensions for Purpose, noted that aside from offering yield and diversification, LGPS funds were increasingly using these assets to generate cashflow as funds matured. She asked the panellists how their funds used the assets, if at all.

Bridget Uku, group manager of treasury and investments at Ealing LBC, outlined her fund’s approach to fixed income: “At present our allocation is purely in corporate bonds and that’s Sterling-denominated, measured against a Sterling benchmark. Although it is UK corporate bonds, 52% of the issuers are international, so we have high exposure to global companies.

“We’re looking for yield, we’re looking for diversification, for cashflow, and protection against the downside. We’re not getting that yield at the moment,” she said.

“We do have a high allocation to equities and we’ve recently made a decision to diversify about 10% out of equities into more high-yielding credit opportunities. Some of that will go into unlisted, corporate direct lending.”

But Ms Uku said Ealing was holding back on any further allocations to high yield bonds because of concerns surrounding the recent high correlation in high yield bond and equity prices.

“You can’t expect them to do well together and not go down together when there’s a downturn, so that is the concern; that correlation,” said Ms Uku.

Jeremy Randall, who at the time was head of finance, strategy and accounting at Kingston upon Thames RBC (but has since retired), said his fund had invested in a Sterling-denominated corporate bond fund and a total return bond fund. He agreed the unusual correlation between bond and equity performance was a worry.

“Historically they were almost negatively correlated, so you would get diversification as a result of holding bonds, but in recent times, quantitative easing has driven growth in asset prices for corporate bonds and that’s one of the main concerns for us; that at some point, as yields tick up and QE is wound in, [we might see] a loss of capital value from our bond portfolios,” he said.

Mr Randall said the Kingston fund had invested in two multi-asset funds, which were “more diversified growth funds than multi-asset fixed income funds” and planned to move away from corporate bond exposure towards both diversified growth and multi-asset fixed income funds.

Phil Triggs, strategic finance manager of pensions and treasury at Surrey CC at the time and now director of pensions at Triborough, said now that the Surrey fund had more than 90% of its liabilities covered, it was looking to allocate less to equities and more to fixed income.

Ms Shackleton, an adviser to four LGPS funds, said the Surrey fund’s thinking was not unusual: “Funding positions have improved considerably since the last triennial valuation and a lot of funds are thinking, ‘let’s try and lock some of that in’.”

Mr Triggs said Surrey had moved much of its UK gilt allocation into absolute return some years ago, although it perhaps made this call a little too early, when there was still “more mileage” in the UK gilt market.

The fund wound down its allocation to corporate bonds, replacing this with multi-asset credit targeting a return of 4-5% per year, and will now look to reallocate money from equities into private debt, Mr Triggs said.

Ms Shackleton asked: “How important is the timing of some of these changes in the fixed income portfolio?”

Mr Cunningham said timing broad strategic shifts from one area of fixed income to another, such as from gilts to absolute return, only accounted for a small amount of the total return to be gained from such plays; the real value came from more granular decisions about what specific issuers and issues to buy within those areas.

“Once you’ve decided your top-down perspective, the real juice comes from the bottom up: which companies do I really like? Which countries do I really like? Which currencies do I like that in? Those decisions should be medium-term,” he said.

Ms Shackleton asked what specific options were available in the emerging markets space.

Mr Cunningham said the growth in emerging markets had been “exponential”, from a “smaller, less liquid” market in the mid-1990s worth $1tn, to one worth $4tn today.

“The mix has changed to some degree. Local currency remains the lion’s share of the universe, but the corporate bond market has been a growth area. That’s good to see because corporate bonds are driven by different things to sovereign bonds,” he said.

“You’ve got companies in there that are driven by international factors. Similarly, you’ve got companies that are sat in Brazil that are driven by factors that are outside of the emerging economies. It

gives you that inherent diversification.”

He added emerging markets issuers had increased “from about 30 countries… to about 70 today”, adding more choice for investors.

Mr Triggs asked: “Are there still the repeat offenders, in terms of defaults, particularly in South America?”

Mr Cunningham said as corporate bond issuance in emerging markets has developed across countries and sectors, corporate governance has steadily improved which has helped mitigate risk of default, reflected in the rating profile of issuers. Argentina was a case in point; Mr Cunningham said President Mauricio Macri’s reforms to restructure the national economy following the default on its sovereign debt in 2014 had reduced the risk of investing in the country. Venezuela, however, remained “the pariah of emerging markets”, he added.

Ms Shackleton asked what concerns pension fund committees may have about allocating to emerging market bonds and high yield debt.

Mr Randall said: “How correlated, if you buy these bonds in these currencies, is the currency risk with the political and economic risk?”

The correlation would depend on the situation in each country, Mr Cunningham said: “[Our analysts’] decisions on whether you invest in a country or not is based on analysis of the fundamentals but also the political landscape.”

This means analysing the value of the bond itself, the risk inherent in the currency, and any upcoming political changes that might affect either.

Ms Uku said currency risk would be a concern for her committee. “You can’t hedge emerging market currency risk because it’s too expensive, but the emerging market currencies did take a nosedive about three or four years ago, so a lot of your income could be wiped out in a currency depreciation,” she said.

“Corporate governance is still an issue in emerging markets,” she added.

Mr Cunningham said investors must assume they will hold a bond to maturity, rather than only a few months, and in doing so, ensure their fund manager’s analysts look at “where its earnings come from, how it is affected by the currency, how is it affected by the political situation” over that longer term.

Further, Mr Cunningham said a bond can sometimes be valuable enough to outweigh the cost of hedging.

“This is the case with Argentina,” he said. “We may say we like the sovereign, and floating rate bonds in Argentina are at around 20% yield today, but the currency we don’t like; we think the currency will depreciate by probably about 5-7%. So, we’re happy to own the bonds and have the exposure to the currency, because we’ll give up 5-7% but we’ll make 20% on the bonds.”

Ms Shackleton asked the panellists how much of their fixed income portfolio they would consider investing in this area.

Mr Triggs said there was a choice to be made between allocating small parts of a fixed income portfolio to specific areas or covering all bases by buying into multi-asset credit.

“The way Surrey has done this is the latter option, so you put a good portfolio size together and negotiate the fee which reflects the portfolio size,” said Mr Triggs.

He added it was essential to ensure committee members were well informed about the way an asset class or investment strategy worked before asking them to vote on investing in it.

Ms Shackleton said: “It’s going to take time to bring your committee to the point where they feel comfortable allocating to this, and then there’s a sudden flow of capital going into the market; then is it too late?”

Mr Cunningham said it was “a justifiable concern” to consider the value of these assets in a context where the Federal Reserve was preparing to wind down QE and investors were flocking into the asset class.

“We all remember 2013 when the Fed turned off the tap and all risk assets fell, particularly emerging market debt and equity markets,” he said.

“Do we think the Fed, turning off the tap, will relive history? So far, the answer is no. The Fed has told everybody exactly what is going to happen, months in advance. You’ll get a rate hike this year and two more next year, and the Fed will continue to taper very gradually.”

Mr Cunningham acknowledged there were large flows into emerging markets and high yield corporate bonds but noted these were institutional investors with long-term investment horizons unlikely to sell off suddenly.

Ms Shackleton asked if the panellists were concerned about the illiquidity associated with investing in other forms of fixed income such as private debt.

Mr Triggs said: “Surrey is comfortably cashflow positive and will be for much of the foreseeable future, so in terms of that requirement to pay pensions on time, liquidity is not such a big factor.”

Mr Harrold asked how illiquid private debt investments were, typically. “We found it hard to pin it down because there is such a range of options available in terms of structure and the risk levels that you’re taking on,” he said. “If 4-6% is what you’re considering on the yield side, what kind of illiquidity or term are you looking at?”

Ms Shackleton said: “A lot of these funds seem to be on five- to seven-year timeframes, and one of the big questions is how quickly can they can get [the money] invested. That can vary from manager to manager.”

Ms Uku said her fund had invested in private debt, but was conscious about the space becoming crowded, driving down yields.

“With fixed income companies taking advantage of low interest rates and issuing for longer so that the benchmarks durations are extending, we are all inadvertently moving to deeper waters rather than staying closer to the shore,” she said.

However, Ms Uku added that private debt investments in the senior space provided some recourse to assets if a company defaulted.

“With high yield, I’m not sure where you are in the capital structure when there’s a default and how much you can get back,” she added.

Mr Cunningham pointed out the default rate among these types of investments was “about 1.5%”, although he conceded, as Ms Uku said, that it was “a muted period” for defaults generally.

“A company will issue across the capital structure,” he said. “Certainly, you have to value where to invest on the capital structure; it’s part of the job.”

Mr Randall said environmental, social and governance (ESG) issues were a primary significant concern for the LGPS in all investments, and particularly will be a consideration in emerging markets and high yield corporate debt.

Mr Cunningham said: “When our analysts are evaluating corporates, that’s what they’re thinking about inherently. Some sectors have more ESG focus than others, for example our metals and mining analyst spends a lot of time visiting with mining companies in Chile gaining a deep understanding of their ESG policies and processes.

“If they’re building a new mine, how does the surrounding environment get impacted by that and what measures do they take? It’s not just evaluated because it’s a tick-box exercise; it’s because that has a material impact on the health of that company.”

Jeremy cunningham

Jeremy cunningham

Jeremy Cunningham

Partner Insight: Funds should appreciate the value of EMD and global high yields

Local Government Pension Scheme investors today employ a diverse and sophisticated array of tools within their fixed-income allocations to meet various requirements for their portfolios. Whether looking to achieve growth, income, diversification or liability matching, there are a host of solutions on offer to help investors meet their needs, including multi-asset credit strategies, corporate bonds, absolute return bond funds, or illiquid alternatives.

We believe that liquid, higher yielding asset classes can play a vital role for investors as part of broader fixed-income allocations. For example, emerging markets debt (EMD) and global high yield are two asset classes that could offer attractive yield, market depth and potential for capital growth; they can also offer diversification, help to reduce volatility as part of a broader portfolio and can help to manage downside risk at a time when many are concerned about high equity valuations.

We think these asset classes are underappreciated in the market today and could represent a missed opportunity for LGPS investors.

The EMD universe continues to evolve and today represents an opportunity set of over $4.6trn1, diversified across asset types (ie hard and local currency sovereign debt, inflation-linked debt and corporate debt), countries, maturities and credit rating. The range of investable securities available is subject to many different drivers of return, giving investors the ability to gain broad and diversified exposure to this growing part of the world, helping to generate returns and increase yield. While yields are attractive compared with developed markets, much of the universe is investment grade (roughly half of the hard currency index and two-thirds of the local currency index).

The high-yield market has enjoyed strong recent returns with spreads close to historical lows, yet income levels have still been consistently high with coupon payments around 5%-7% or higher. Through active credit selection, an investment in high yield can potentially deliver a regular income stream through bond coupon payments, as well as capital appreciation through possible upgrades to credit ratings. The high-yield market has depth and offers exposure to a range of sectors; combined, the dollar, euro and sterling high-yield markets have a value of $1.3 trillion, and represent some 2,200 issuers.2

As pooling provides a prompt for LGPS investors to rethink their investment approach and the potential to access broader opportunities, EMD and high yield are two asset classes that could benefit from fundamental research and active management, and can help deliver strong income and growth in support of overall portfolio returns.

1. Data as at 30 September 2017. Based on aggregate market value of JPMorgan EMBI Global Index; JPMorgan GBI-EM Broad Index; JPMorgan CEMBI Broad Index; Bloomberg Barclays EMGIL Bond Index. Sources: JPMorgan, Bloomberg Barclays

2. Data as at 30 June 2016. Based on Bloomberg Barclays US High-Yield 2% Issuer Cap Index. Source: Bloomberg Barclays

FOR PROFESSIONAL INVESTORS ONLY*

* This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein. The information provided is intended to highlight issues and not to be comprehensive or to provide advice.

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.

• The value of shares and income from them can go down as well as up and you may lose some or all of your initial investment.

• Past results are not a guide to future results.

• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease.

• Depending on the strategy, risks may be associated with investing in emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.

This communication is issued by Capital International Limited (authorised and regulated by the UK Financial Conduct Authority), a subsidiary of the Capital Group Companies, Inc. (Capital Group). This communication is intended for professional investors only and should not be relied upon by retail investors. While Capital Group uses reasonable efforts to obtain information from sources which it believes to be reliable, Capital Group makes no representation or warranty as to the accuracy, reliability or completeness of the information. This communication is not intended to be comprehensive or to provide investment, tax or other advice. © 2018 Capital Group. All rights reserved.

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