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UK pensions: a return to bonds for the new generation

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Asset manager Payden & Rygel underlines the case for fixed-income investments.

The inflation shocks of the second half of 2022, have, for the first time in a generation, prompted renewed enthusiasm among pension fund managers for fixed-income investments, according to Payden & Rygel, one of the largest privately-owned global investment managers.

“For the past 10 to 15 years, fixed income has primarily been used by UK pension funds as a matching asset, typically as part of an LDI approach and often supplemented by allocations to near cash and cash plus strategies as part of a liquidity waterfall,” said Mark Stanley, Director – Payden & Rygel – London.

“The low yields in liquid fixed income led many to explore allocations to private markets, sacrificing near-term liquidity for higher long-term yields.  However, yields spiked significantly across liquid fixed income following the “Mini budget” creating two significant shifts: Liquidity suddenly became more important and yields in public markets are now very attractive,” he continued.

Developing these themes, Mark Stanley added that, “Pension fund trustees are now focused on ensuring they have adequate liquidity for collateral calls while at the same time being more prepared for buy-out opportunities.  Multi sector fixed income portfolios offer attractive yields in sterling terms, while taking on relatively little interest rate risk; 6 to 8 per cent yields are achievable, and these can be enhanced further through dedicated allocations to high yield bonds and emerging markets debt.”

“There are, however, a series of challenges facing fixed income assets,” said Nigel Jenkins, Managing Director, Payden & Rygel – London, who listed a range of issues including the prolonged upturn in inflation, global central bank tightening, 2023 recession risks, and geo-political instability as being particularly consequential.

“While we think that inflation rates almost everywhere have likely peaked, longer-term inflationary pressures, which include the price effects of transitioning to greener energy sources, de-globalization or re-shoring to secure supply chains, and China being less of a source of cheap labour to the rest of the world, may make a move back to a sustained 2 to 2.5 per cent inflation rate quite difficult to achieve.”

Speaking specifically of recession risks, Nigel Jenkins added that, “In our view, financial markets are currently pricing in a pretty shallow and short-lived recession, and risks seem tilted towards a more sizeable contraction than that. If so, riskier components of fixed income markets that are more levered to the economic growth cycle e.g. high yield corporates and emerging markets may have a tough time for some of next year in a weaker economic environment.”

In conclusion, however, Nigel Jenkins underlined the importance of fixed-income investments in establishing stable pension fund portfolios. “2022 was an exception to the rule that the performance of equities versus cash and riskier credit securities versus same-maturity government bonds are typically both negatively correlated with the performance of Government bonds. This is the genesis of the stability that fixed income can provide to equity and other risk asset-heavy portfolios. 

“When economic growth is the volatile component of nominal growth rates, which we think will be mostly true again in the future, this relationship should reassert itself, he continued.  “The challenge last year was inflation variability, leading to interest rate increases, weaker government bonds, and (via consequent expectations for weaker growth) falls in equity prices and higher risk components of global bond markets. Whilst inflation volatility may be a bigger issue on average over the next 10 years than it has been over the last 20, for the most part we think it will once again be economic growth expectations that will be the dominant factor. And in that environment, fixed income assets should again provide stability in a balanced portfolio allocation.”

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