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Bond investment - a case for non-gilts?

Mark Da Silva considers the arguments for UK occupational pension schemes investing in bonds other than those issued by the UK Government. Please contact your Barnett Waddingham consultant if you would like to discuss any topics in more detail.

  1. Is it time for pension schemes to increase their exposure to non-gilt bonds?

    • There are signs that pension schemes have recently been reducing their exposure to equities in favour of fixed interest investments* - including both gilts and non-gilt bonds - principally in response to increasing scheme maturity, brought into focus for some schemes by Minimum Funding Requirement (MFR) considerations. (It is worth re-iterating, however, that the MFR does not itself require investment in fixed interest stocks. Indeed, many schemes prefer - and in the opinion of many actuaries should prefer - to hold a lower proportion than might be implied by an MFR-matched portfolio.)
    • However, the supply of new gilts has been limited recently due to the Government's reduced need to issue debt to finance expenditure. Indeed no new gilts have been issued recently and some economists believe none will need to be issued for the next couple of years. These factors coming together have brought about what might turn out to be an artificial upward pressure on gilt prices (and hence downward pressure on yields). The effect is particularly marked at the long end of the gilt market, because pension schemes and insurance companies tend to prefer longer dated issues. This has led to an unusual downward sloping gilt yield curve, illustrated by the following yields available at the beginning of the year:

      Term (years) Yield
      5 5.1%
      10 4.8%
      15 4.6%
      20 4.5%

    • At the same time (and by coincidence?), the liquidity of the non-gilt bond market has improved through a number of recent large issues, and this has corresponded to downward pressure on prices and increased yields. Indeed, the non-gilt sterling bond market is nearly as large as the gilt market now, and many predict it will overtake soon.

  2. What are non-gilt bonds?

    • A non-gilt bond is a debt security (or loan note) offering a fixed annual income and capital redemption in the same way as a gilt. They may be issued by companies (known as corporate bonds) or international institutions and supra-nationals. Because there may be a risk of default (and lower liquidity which means they may have to held until maturity or default if the market turns against them) non-gilt bonds typically offer returns higher than those available on gilts of equivalent term; the additional return available reflecting the additional risk of the bond.
    • Non-gilt bonds are risk-rated by rating agencies such as Standard & Poor's. Credit ratings range from AAA for the most secure and marketable issues down to D for those most likely to default and most difficult to trade. Low grade bonds are often termed "junk bonds", and only the higher rated bonds would normally be regarded as investment-grade and considered for inclusion in the portfolios of investors such as pension funds. Investment-grade would usually imply a majority of AAA and AA issues (AAA lenders might include, for example the World Bank or the European Investment Bank, whereas AA lenders might include some of the largest FTSE companies or local government authorities) with a minority of A or BBB issues (perhaps other FTSE corporate bonds).
    • Credit ratings on bonds can change from time to time - for example recently some bonds issued by several of the large telecoms companies were downgraded from AA to A after they raised substantial additional capital to fund their acquisition of third-generation mobile phone licenses. The price of a bond can be expected to change when its credit rating is upgraded or downgraded. This is a source of additional volatility compared with gilts, and also an opportunity for an investment manager to add value by anticipating such movements.

  3. How much extra yield do non-gilts offer?

    • Many investment houses believe that non-gilt bonds look underpriced currently when compared with gilts of equivalent term even after allowing for any risk of default. Compare the following investment-grade yields available with the gilt yield at the same date (across bonds of all terms):

    Credit rating Yield
    Gilts 4.6%
    AAA 5.4%
    AA 5.9%
    A 6.4%
    BBB 6.9%

    Is diversity important?
    • Yes, definitely. We believe diversification is a more important consideration for a non-gilt portfolio than a gilt portfolio because of the credit risk attached to individual non-gilt investments. The value of corporate bonds issued by a particular company may be related to the value of shares in that company, since both reflect the risk of investing in the same enterprise. In the same way that it is sensible to diversify equity investments it is normally appropriate to spread a corporate bond portfolio across as many issues and issuers as possible. This requires careful management. Pooled funds are often a convenient vehicle for achieving appropriate diversification.

  4. Does the performance benchmark need to change?

    • Although a non-gilt bond would normally be expected to yield a higher return than an equivalent gilt over the duration of the bond it will, as mentioned earlier, be subject to different short-term market pressures. For this reason inclusion of non-gilts as part of a pension fund's bond strategy will normally require a review of the investment benchmark to ensure consistent measurement of performance over the short-term. It also serves to distinguish genuine long-term outperformance of the bond manager, as opposed to simply confirming that non-gilt bonds have indeed out-yielded gilts.

  5. Isn't the MFR basis being reviewed?

    • Consultation on the proposed MFR review finished at the end of January, and it may be that in future the MFR test might make reference to non-gilt bond yields as well as gilt yields. In due course, this could lead to increased pension fund demand for non-gilt bonds as opposed to gilts which would cause pressure on the yield gap discussed above to close (all other things equal).

  6. What about index-linked bonds?

    • Many pension schemes allocate some of their bond portfolio to index-linked gilts, rather than fixed-interest gilts, as better matched protection for inflation-related pension liabilities. Currently the index-linked non-gilt market is very small, and so schemes would have to accept greater inflation-related risks in pursuing a non-gilt strategy. However, some market commentators would argue that inflation protection is less important now than in the past, with inflation arguably under greater control - with political lessons perhaps having been learned from past mistakes.
    • There is also an argument that index-linked gilt yields have been affected by recent increased demand from pension funds to an even greater extent than fixed-interest gilts.

  7. Concluding comments

    • We believe that the liabilities of a pension scheme, the funding strategy, and the tolerance of the trustees for investment risk should drive the strategic asset allocation of the scheme, and in particular the balance between equities and bonds. We also believe that exposure to a diversified portfolio of non-gilt bonds, compared with a gilt-only strategy, may offer the opportunity for enhanced fixed interest returns for only a small amount of extra risk, thus improving the overall risk-return relationship.
    • Whether it is appropriate for a particular scheme to invest in non-gilt bonds, the extent to which a scheme's bond portfolio that might be allocated to non-gilts, and the timing of such investments, are all important strategic and tactical asset allocation decisions that should be discussed with the trustees' advisors and investment managers in the light of the specific circumstances of the scheme.

Mark Da Silva, March 2001.