The recent sell-off in corporate bonds has shown that there are few places left untouched by the current market volatility, but do pension fund trustees need to worry? 

 

Last week, corporate bond yields were driven higher again, while equities have also seen sharp falls in recent weeks as investors are concerned about higher interest rates and low growth. The Bank of England’s base rate rose from 0.1% to 1% in the space of five months as 12-month inflation hit 7% in March. In the US, the Federal funds rate is at 0.75%-1%, while inflation was at 8.3% in April, as supply chain issues and steep energy price rises linked to war in Ukraine take their toll.  

   

 

   

    

The traditional model of diversification does not work in such a scenario; bonds have been hit as much as equities.  

 

   

However, the movement in corporate bonds has not been seen as universally negative. “Corporate bond spreads have been tight, arguably too tight to reflect the ongoing pandemic, political instability, tightening monetary policy, the souring energy prices and supply chain disruption,” said Natalie Winterfrost, a director at LawDeb Pension Trustees. 

 

For pension funds, this should “certainly be seen as a more attractive entry point”, therefore, as most schemes need a return over gilts and so have to take some risk; the advantage with corporate bonds being that they rank above equities when a company is in distress. “The recent sell off in corporate bonds just improves their attractiveness versus equity markets,” said Winterfrost. 

 

The higher yields on publicly traded corporate bonds also means pension schemes might now be able to lock in the excess yield they need without having to consider private markets, she noted, warning however that diversification is crucial – so private markets should still not be completely ignored. 

 

Markets are less benign than they were in the past few years, but Winterfrost advised pension trustees not to overreact. “While there is clearly a risk that corporate bonds might yet get cheaper and the market will likely remain volatile, pension schemes must try to remember they are long term investors and look beyond this current volatility,” she noted. 

 

 

Schemes have the time horizon to ride out the storm, but taking some losses might be inevitable, and could have knock-on effects on their long-term objective. 

 

“Equities and bonds have been selling off at the same time. There is nowhere to hide,” said investment specialist at Dalriada Trustees, Brendan McLean. Funding levels of some schemes will have gone down as a result, he noted, meaning it will take pension funds longer to achieve their endgame – and they might even have to ask their sponsor for higher contributions. 

 

One subgroup of schemes will have welcomed the higher yields of corporate bonds, however. “It’s not all bad,” said McLean, as “the rise in interest rates means schemes without much hedging would have benefitted”. 

 

While this is not the first time that bonds and equities have been hit at the same time – the 2008 financial crisis caught many pension funds out – today, defined benefit schemes are much more exposed to fixed income than they were 15 years ago, having closed to new entrants or accrual. But how hard a scheme has been hit by the recent moves all depends on “how well they constructed their portfolio”, McLean said – in other words, how a scheme has matched durations. 

 

 

The GDP figure for the first quarter was still positive, but growth steadily declined over the quarter. There are now growing fears of a recession this year, generally defined as two consecutive quarters of negative growth. If such a contraction or low growth is combined with inflation, the economy could end up in a stagflation scenario, something that was last the case in the 1970s – and was painful to come out of, with high interest rates and unemployment. 

 

So where can investors put their money? The inflation scenario means infrastructure and other real assets are “a way to navigate this environment”, noted McLean, because the underlying payments – the tolls, rents and fees levied for using them – are often linked to inflation.  

 

How will this environment affect fund managers? “There will be some surprises,” predicted McLean, as all parts of fixed income are being sold off. Multi-asset credit funds have little space to hide, he said. The only area that has some interest-rate linkage is leveraged loans. 

 

Investors had better not hope for a significant bounce-back. “Investors will ultimately have a big loss this year,” he said. “They've had the good times, fixed income has done very well; that’s over." 

 

Perhaps unsurprisingly, fixed income asset managers are still somewhat more positive. Schroders’ global head of credit, Patrick Vogel, warned that the war in Ukraine was unpredictable and that unlike the UK and US, Europe was particularly vulnerable to energy shortages. 

 

However, in March he said that credit valuations are now more appealing, with yields offering better income prospects even than equities. “Credit can also act as a diversifier should growth falter more than expected,” he said, as the income cushions the impact, while higher grade corporate bonds are less sensitive to growth than stocks. “These factors should make credit attractive to a wider, non-specialist investor base, potentially spurring institutional investors or multi-asset funds to increase allocations.” 

 

But he said there was “a growing need to be selective” as companies face rising input cost pressures, which could worsen and impact revenues if energy prices go up further. 

 

 

Natalie May Winterfrost

Brendan McLean

Simon Cohen