Click here for Myles Bradshaw's biography and Jeroen van Bezooijen's biography.

Since August last year, we have become accustomed to “bad news,” be it the runs on Northern Rock or Bear Stearns, higher mortgage rates or weaker economic growth. But every cloud has a silver lining, in this case for UK pension funds. Wider risk premiums have created opportunities for unlevered investors to earn higher returns. UK pension funds fall into this category as they typically do not borrow in order to invest. So how can pension fund investment strategies exploit the recent market dislocations?

From pension fund deficit to surplus¹
Under accounting rule FRS 17, pension funds discount their liabilities by rates derived from the AA corporate bond yield curve. Yet one feature of the liquidity crisis has been a sharp widening in credit spreads. For example, the bellwether of the European credit market, the Main iTraxx CDS 5-year index²  spread traded at 22 basis points (bps) over swap rates before the crisis came to a head in August 2007, but widened to a high of 160 bps by March 2008 when risk aversion reached its peak.

Higher discount rates mean lower pension liabilities and a better funding position – other things equal. So while gilt yields³  have fallen by around 0.4% since May 2007, the yield on the AA Merrill Lynch Sterling Corporate index has increased by around 1%. As a result, Watson Wyatt estimates that the FRS 17 deficit for the companies of the FTSE100 index has improved by about £80 billion since last summer to a 107% funding level at the end of April this year, from a level of around 90% in June 2007.

In this instalment of the European Perspectives we highlight three ways pension funds can potentially benefit from these market conditions and make the surplus stay:

1. Wider credit spreads may offer the opportunity to earn equity-like returns on fixed-income investments.
2. For pension funds with limited price indexation (LPI)⁴ liabilities it appears advantageous to replace index-linked gilts with corporate bonds, as the spread versus the worst case indexation outcome (i.e. 5%) is higher than the long-dated index-linked gilt yield.
3. Tight swap spreads in the long end mean that long gilts look attractive versus long swaps.

For pension funds that have adopted or are considering adopting a liability-driven investment (LDI) strategy, all the above points indicate that a “hands-on” active management approach likely offers more value than a passive “implement-and-forget” approach to LDI.

A better match
Wider credit spreads are not only good news for pension funds because of their impact on the FRS 17 funding levels. Buying credit at current spreads also provides pension funds with an interesting opportunity to earn equity-like returns with fixed-income investment risk levels.

Since the 160 bps panic levels of March 2008, spreads as measured by the iTraxx Main index, have fallen back to 75 bps in mid-May. Yet this is still almost four times the pre-crisis levels and implies a default rate of 5.7% against the average 5-year cumulative default rate of less than 1% as measured by Moody’s. This average default rate equates to about a 20 bps annual loss (compared to an annual spread earned of 75 bps). On the downside, the worst cumulative 5-year default loss (since 1970) has been 3.5%, or about 70 bps per annum, which is still below the current spread earned.

The higher implied default rate reflects the expectation that weaker economic growth will be a drag on credit fundamentals going forward. This risk is more than adequately priced into the investment grade credit market with ratings of BBB and higher. (NB: High yield bonds with ratings of BB and lower are a different story). So, as an asset class we think investment grade credit is attractive.

PIMCO has estimated that at current levels, the spread on BBB corporates is indeed close to the typical equity risk premium assumption of 2-4% as shown in Chart 1. This means that pension funds can now switch from equities into (corporate) bonds without having to sacrifice as much return or inject as much capital as in the last decade. At the same time they can move higher up the corporate capital structure. In short the “crisis” has improved the terms for pension funds to better match their assets and liabilities by switching from equities into bonds.

The benefits of using the iTraxx CDS indices is that pension funds do not need to invest £100 of cash to get £100 of exposure. As with other derivatives contracts, investors only need to have physical cash or other collateral (such as gilts) to cover the initial and subsequent variation margins. Pension funds can therefore sell protection on the iTraxx Main index as an overlay strategy over their existing bond portfolio in an effort to boost returns and reduce the mismatch risk between the discount factor on their assets and the FRS 17 discount factor on their liabilities.

Credit – cash bonds or derivatives?
A key feature of this liquidity crisis has been the premium that has been placed on cash bonds over their credit default swap (CDS) contracts. Thus while the spread on the iTraxx Main Index is 75 bps, the spread on its nearest equivalent, the ML Euro Corporate index, is 114 bps. Indeed, the spread on the typical corporate cash bond is on average 40-50bps higher than the spread on their own CDS. As a result, another premium beckons in UK pension funds’ natural home: long-dated sterling assets. The ML >15-year non-gilt index offered investors a premium of 133 bps over gilts in the middle of May, around twice the excess yield offered before the crisis and the highest spreads since 2000 (see Chart 2).

While the investment strategy seems clear, the implementation is less straight-forward. For a start there is the issue of liquidity. Using ML indices as a guide the 15-year+ non-gilt index is £116 billion in size against £142 billion in the 15-year gilt index. However, the gilt index underestimates the true size of the long-dated interest rate market in the UK because it excludes the swaps market. Liquidity is in fact much poorer in long-dated non-gilts with bid-offers typically in the range of 0.5%-1% as opposed to 0.1% - 0.15% in long gilts. A second problem is duration. The gilt index has a duration of 14.9 years compared to 11.9 years in the non-gilt index, but this can easily be remedied by extending asset duration with an interest rate overlay. A lesser concern is the ratings, since most non-gilt issuers are of high quality; the average rating on the non-gilt index is AA2.

Adding up the pros and cons, pension funds may be better off with long-dated investment grade corporate bonds. Despite the limitations of the lower liquidity and smaller size of the long-dated corporate market, the excess yield currently available more than compensates for this. Given the excess yield, pension funds with gilt assets may want to think carefully about whether they would not be better rewarded through long-dated investment grade corporate bonds instead of gilts.

The trick with inflation
The high yield offered by long-dated corporate bonds also has implications for pension funds’ inflation strategy. This is especially the case with respect to liabilities with LPI indexation which account for a large part of many pension funds’ liabilities. The current inflation picture appears relatively bleak. Let’s start with the Bank of England’s (BoE) inflation target of 2% measured by the consumer price index (CPI). A CPI inflation of 2% is consistent with the UK’s other inflation measure, the retail prices index (RPI), between 2.5%-2.7% (depending on house price inflation assumptions).

Long-dated index-linked real yields currently range between 0.5%-1%, implying break-even rates of inflation between 3.65% (for 15-year bonds) and 3.8% (for 30-year bonds). Consequently, this market pricing implies that the BoE will fail to maintain inflation near its 2% target on average for the next 30 years.

We know that 30-year break-even inflation rates are so high (and real yields so low) because of a distortion created by structural demand from pension funds seeking to hedge their inflation-linked liabilities. For if the market truly did think the BoE would miss its inflation target then the yield curve section between 10-30 years should be steep, rather than inverted, to compensate investors for the higher expected inflation over the period.

However, LPI requires schemes to index liabilities to RPI inflation subject to a ceiling of (usually) 5%⁵. There is a derivatives market in RPI and LPI inflation swaps (whereby the investor agrees to pay/receive inflation and receive/pay a fixed rate) which suggests the respective inflation expectations. Thirty-year RPI swap break-even rates are currently at about 3.8% while 5%-cap LPI swap break-even rates stand at 3.7% – this is again inconsistent with the BoE’s inflation mandate. Given 30-year nominal interest rate swaps of 4.7%, this equates to a real LPI yield of 1%. In other words, pension funds would receive a 1% yield plus RPI inflation, subject to a cap of 5% in any one particular year.

Putting all the pieces together, the widening in credit spreads means that pension funds can now buy long-dated non-gilt assets yielding 6%-6.5% as of mid-May. Thus, the yield will exceed the indexation by at least 1%-1.5% as this is capped at 5%. If the BoE succeeds in hitting its inflation target (and delivers RPI of 2.5%), pension funds will have captured an additional 2.5% per annum by buying long-dated non-gilts (yielding 6%-6.5%) rather than receiving a 1% net yield (based on fixed nominal rates of 4.7% less the fixed coupon of 3.7% to receive 30-year LPI inflation). If the BoE fails to meet its inflation mandate, then the pension fund is no worse off as the maximum their liabilities can increase in any one year is 5%. Given the general expectation of economists and policy-makers that the inflation target will be met over the long-term, this sounds like a good value proposition with limited downside risk.

Choosing the right tool when increasing duration
It has become increasingly popular for pension funds to increase asset duration by receiving swaps rather than buying gilts. This largely reflects the greater customisation of swaps and the deeper liquidity of the market. For example, pension funds can decide both the start and their final maturity of the swap, be it 30 or 47½ years.

But when pension funds receive fixed rates they also commit to paying floating rates (six-month LIBOR) to their counter-party. And one feature of this liquidity crisis has been the sharp rise in LIBOR rates. Six-month LIBOR stood around 5.8% in mid-May, some 80 bps over the risk-free rate (defined here as the six-month Sterling Overnight Index Average (SONIA)), up from about 15 bps before the crisis. This would be less relevant if 30-year swap spreads had also widened.

However, partly because of this structural demand from pension funds to hedge inflation-linked liabilities, the spread between 30-year swap and gilt rates has narrowed to less than 20 bps from about 35 bps prior to the crisis. So, by receiving fixed rates, pension funds are now receiving 20 bps over the risk-free fixed (gilt) rate and paying 80 bps over the risk-free floating rate. This 60 bps cash flow deficit is unlikely to remain so wide for the duration of the swap (indeed, the market discounts that this spread will fall to 20 bps by early 2010). Given the increased focus on liquidity ratios, though, the deficit is unlikely to fall back to pre-crisis levels. In short, the cost of receiving on long-dated swaps has gone up since the crisis began.

Pension funds now need to earn an additional return on their cash assets in order to offset the higher LIBOR rates. So what should pension funds do about this? Those looking at implementing swap overlays may consider re-assessing the merits of implementing the same strategy using cash bonds – whether they are gilts or corporates. If cash bonds are not an option, schemes can alternatively look at using forward starting swaps. This strategy postpones the need to exchange cash flows to when conditions might be more favourable.

Becoming active
The strategies outlined above indicate the many ways in which pension fund investors in the UK market can benefit from recent market events, especially with respect to LDI strategies. While the opportunities are out there, schemes need to make an active decision to participate. In this environment, a passive “implement-and-forget” approach to LDI is likely to be sub-optimal. Schemes likely need to become active or enlist the help of a hands-on asset manager to exploit the opportunities on offer and make their surplus stay.

Myles Bradshaw
Vice President

Jeroen van Bezooijen
Senior Vice President


¹ Market prices, yields and spreads quoted were taken on 13 May, 2008.
² The iTraxx Main index consists of the most liquid 125 investment grade names and has an average rating of A.
³ Using 10-year gilt yields.
⁴ LPI typically caps inflation at 5% (and floors at 0%).
⁵ For example: If inflation is 10% in Year 1 then the liabilities will only increase by 5%.