What we have seen

Bonds have had a rough 18 months. The events of Q4 2022 and continued rate hikes into 2023 have resulted in persistent sell offs, especially for those longer duration bonds. But, over the last 6 months, we have observed a material dispersion between credit and gilts – with the former materially outperforming and with shorter dated products in general performing stronger given long term market uncertainty in a higher for longer world.

However, how ‘high’ will rates be and for how long? Looking ahead, with the headline inflation rate now falling across major developed economies and rate cuts expected to begin in 2024 and continue through 2025, bonds may once again be an attractive asset class as we enter the new year.

In DC, whilst strategic allocations clearly dominate asset allocation decisions, market events, performance, and subsequent expectations drive topical discussions and, at present, bonds are very much part of this discussion.

How it relates to DC

Members approaching retirement are susceptible to large market downturns having a clear and tangible impact on their retirement outcomes (with 2022 a case in point). Further, members who have begun de-risking have a relatively short investment horizon to make up losses and, therefore, Trustee focus on mitigating market risk at this stage of the journey is key. To manage this risk, the majority of DC strategies use bonds in the de-risking phase.

Annuity lifestyle of course use long duration bonds to better proxy changes in annuity prices and these funds have been in the spotlight over the last 18 months, with the 30%+ drop in performance since September 2022. But annuity fund falls have at least been matched by a corresponding improvement in the price of annuities, meaning that members are no worse off and, in many cases, have seen this purchasing power improve as a result so long as they intend to use their pension savings to buy a guaranteed income.

However, a more important focus of Trustee time is the bond allocation in cash and income drawdown lifestyle strategies. Here the focus is very much on picking the right type of bond allocation to protect members from adverse market conditions having a detrimental impact on their pension pots. As such Trustees will be asking themselves, could a better choice of bond have defended more effectively against the significant headwinds experienced over the last two years? Should any bond allocation be dynamic to pick up any potential tail winds we may enjoy in the future? In the absence of increasing duration (given this comes with risk) the answer for many schemes should be to go or remain active.

Why active management?

The benefits to using active management in your bond allocations are clear.

1. The nature of passive index credit construction means you end up buying more of the most indebted companies. So-called ‘sinners, not winners’. Starting with a blank sheet of paper, clearly this is a questionable method for allocating capital.
2. Less flexibility to adjust positioning to reflect current opportunities and market conditions. For example, passive Investment Grade credit indices have around half allocated to BBB rated issuers (one notch above the High Yield market). Passive manager methodology forces sales in downgraded bonds at a time when others are also forced sellers, which is likely to negatively impact market values. For example, Ford over the last decade has fluctuated between being High Yield and Investment Grade but has never defaulted (i.e., patient, long-term investors have been paid). Managers should therefore be allowed to assess the relative risk of any downgrade and potential upside, rather than being forced to sell. They should also be able to move up and down the credit spectrum based where they see best value, especially for DC investors who are likely to be invested pre-retirement for less than a market cycle.
3. The incremental fee increase for active management is arguably much lower than in other asset classes like DGFs and equities. In bond markets, active strategies typically have a 20-30bps increase on passive mandates, rather than 60-70bps in other asset classes.  So, it doesn’t take much outperformance to compensate for this additional cost.
4. Easier to incorporate responsible investment (“RI”) and climate change considerations. There is a real emphasis on climate-tilted equity funds in the accumulation phase of DC strategies. Most of the Trust based Schemes I advise now have an accumulation phase that materially reduces the carbon footprint of member investments. Over 2023 I have been focusing more on better incorporating RI and climate change considerations into the decumulation phase of lifestyle strategies and active bond allocations are the next natural consideration.

What about ABS as an allocation?

When DC schemes have used active bond mandates in their default, they have tended to use short duration credit or absolute return bond funds. But asset backed security (“ABS”) funds could have a role to play, given their return and risk characteristics.

• Return: Many ABS funds are currently achieving an attractive yield of 8.5% for investment grade assets. This could mean that an allocation to ABS could really be attractive as a supplementary allocation be alongside more traditional active bond funds used in DC lifestyles, especially for drawdown targeting lifestyles. Especially when compared to absolute return bonds for example, ABS returns are more market driven and funds are typically much cheaper products.
• Volatility and downside avoidance: Given these funds are likely to be used in the de-risking phase, it seems counter intuitive to consider an opportunity offering such attractive returns because of the associated risk. However, relative to the broader opportunity set available to DC schemes, the rationale for ABS from a risk perspective is clear. For example, one of the managers we rate has a credit spread of ~3.3% (the expected yield is ~3.3% more than cash rates which are currently c.5.25%) and yet given the low sensitivity of these funds to changes in interest rates, the expected volatility is no more than many of the other DC bond funds we regularly use. 

I think that there is a strong case for considering an active bond allocation in the de-risking phase of the lifestyles we monitor. This is true whether your objective is to incorporate ESG more effectively, offer members better value net of fees, or purely from a risk-management perspective.

If you are considering adding active bonds to your Christmas list, why not cast your eye over ABS funds. You may be pleasantly surprised; the DC appropriate ABS funds that we rate aren’t naughty…they are nice!