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Waking up to a new decade on 1 January 2020, a world of pension scheme promise lay ahead. With the US elections later in the year, a relatively calm year in markets was anticipated and attention could be focussed on longer-term strategy.
Less than two days later it seemed this was not to be the case. Australian wildfires and a drone strike in Iran demonstrated the potential for crisis to emerge on a global scale. Heavy falls in oil prices were a timely reminder to investors of the investment risks that prevailed. Nonetheless, equity markets continued their climb, reaching all-time highs in mid-February. For schemes who ended up ahead of plan on their funding journey at the start of 2020, we helped many with de-risking out of growth assets to lock into some of the gains experienced.
But little prepared anyone for the turbulence to come in markets caused by the spread of the novel coronavirus around the world. Over the month to 23 March, equity markets fell by over 30%, with other return-seeking assets seeing comparable sell-offs.
With markets spooked by the huge uncertainty that lay ahead, gilt yields (and therefore pension scheme liabilities) swung significantly, with real yields spiking over almost 0.8%p.a. above their previous lows over the course of a few short days. Savvy schemes managed to increase their liability hedging by capitalising on the sudden cheapening of index-linked gilts. The volatility also demonstrated the importance that we place in building the robust collateral management processes that support our clients’ leveraged liability hedging portfolios, as rises in gilt yields led to cash calls to meet collateral calls. As yields subsequently fell back, it is clear that those who we have helped to build up significant amounts of liability hedging will have weathered the storm better than those without.
20-year real gilt yields
Central banks soon stepped in to provide calm by pumping massive amounts of stimulus into markets, with the size of asset purchases announced dwarfing even those of the global financial crisis. Demonstrating the need to do “whatever it takes” to support markets led to equity markets remarkably regaining much of the losses they’d suffered over March, coupled with yields falling to new lows. Schemes that had held their nerve and retained return seeking assets, in addition to those we assisted with rebalancing of investment strategies, saw investment portfolios rebounding in value.
FTSE All-World All-World: Local currency total return index
With short-term catastrophe avoided for the majority, attention could also be focussed on opportunity. We have been helping clients with a number of potential opportunities brought about by the crisis:
Given the impact of lockdowns on revenues, many companies are struggling to pay their debt. This pushes their credit rating down and thereby the price of their debt, as investors are either forced to sell (e.g. due to rules within their funds) or selling because they are nervous about the downgrade. However, sometimes the company fundamentals remain solid and the company can be expected to recover – in some cases this will be with significant external input/restructuring (distressed debt) but, in other cases, the company will recover on its own (stressed debt). We think there are lots of opportunities to find solid companies with debt trading below face value, meaning investors can benefit from higher returns without a commensurate increase in the default risk.
“Fallen Angels” typically refer to bonds that were initially rated as investment grade but have since been downgraded to high yield due to a deterioration in the issuer’s credit rating. A huge number of downgrades are expected as a result of Covid-19 which may push some bonds out of investment grades status. Pension schemes invested in certain investment grade bond funds, e.g. index-tracking funds, may be in the undesirable position of being forced sellers of these bonds, which has often been the worst time to sell.
Therefore, we have been reviewing our clients’ exposures to investment grade bond funds, understanding their permitted allocation in high yield bonds, and if at danger of being a forced seller, revising clients’ mandates. In addition, we have seen funds specifically targeting this opportunity being launched which are available for pension scheme investors.
In light of the market turmoil over the first half of the year, many investors are either being forced to – or may wish to – sell their illiquid asset holdings (e.g. in private equity, private debt). Since, by definition, these funds don’t have a well-functioning market they cannot be easily sold. In practice, investors can only do this on the secondary market. This may lead to an excess of supply and a potentially significantly discounted price, thus presenting an opportunity to those that are able to take on the illiquidity.
The pandemic is far from over and being able to protect the security of pension member benefits through a scheme’s investment strategy remains paramount. What is clear so far is that well managed schemes have been much better placed to avoid funding volatility and access the opportunities presented by the crisis.
Finally, to summarise the ‘top-tips’ that we would highlight now that the dust has settled on a turbulent six months:
Plan ahead: Clients that have a clearly-defined long-term strategy and have been regularly monitoring their progress towards it have been in the best position to ensure they weren’t taking any unnecessary risks going into the market downturn.
Risk management is key: Those who had managed the risks within their scheme were better placed to withstand the market volatility and falls in gilt yields. Despite gilt yields being at record lows, uncertainty remains over what will happen in future. Being on top of all of your scheme’s risks (including interest rate, inflation and ESG (Environmental, Social and Governance) factors) will ensure schemes are positioned to withstand future crises.
Take advantage of opportunities: Opportunities often arise out of adversity and schemes that are poised to take advantage of these as they emerge will be able to access most effectively.
If you’d like to discuss in more detail the actions we’ve been taking to help our clients navigate these choppy waters, please do get in touch.