“There are decades where nothing happens; and there are weeks where decades happen,” is an expression often attributed to Russian revolutionary Vladimir Ilyich Lenin. While it is disputed whether he actually said it, the UK bond markets are a case in point. Between late September and early October, decades of investment consensus unravelled.
Seemingly rock-solid interest and inflation hedges crumbled within hours under the weight of collateral calls, turning some of the country’s largest defined benefit (DB) schemes into forced sellers of anything investors would buy.
As DB schemes threw the metaphorical kitchen sink at preventing a liquidity crunch, stock markets plunged, the pound fell and property funds were forced to stop institutional investors from withdrawing their capital.
While a storming of the Winter Palace was ultimately averted with the Bank of England stepping in and the government swiftly changing course under new leadership, the consequences of those weeks of turbulence in the autumn are likely to shape the British economy for years to come as the country braces itself for higher borrowing costs and austerity.
Just like the revolution of October 1917, turmoil in the bond markets did not occur in isolation. The backdrop is a sea change in macro-economic factors, from rising inflation to monetary tightening, volatile stock markets and risks of recession, investors are facing a new normal.
As the dust settles on the bond market meltdown, investors are taking stock. Will changes in the economic environment prompt adjustments to institutional investment strategies for 2023?
The cost of living
A key question going forward is how persistent will inflation be. At the time of writing, the UK consumer price index (CPI) hit 11.1%, while across other developed markets, price rises remain in double-digit territory. But despite the sharp spike, central bankers are confident that inflation will eventually settle down. The Bank of England expects prices to fall back to 4.2% by the end of 2023 and reach their 2% target in 2024. But many investors are cautious. More than 70% expect UK inflation to remain above 3% for the next five years, according to the IMF.
For Mike Eakins, chief investment officer at Phoenix, an insurer, inflation and monetary tightening will continue to dominate in 2023. “Inflation is not suddenly going to decline; we will see it begin to taper off but the pace of that is uncertain,” he says. Eakins predicts that geopolitics and the weather could be the decisive factors influencing price levels in 2023. An escalation of the Russia-Ukraine war and a colder winter could trigger higher energy prices, while an end to the hostilities and a warmer winter could help lower them.
Inflation is also high on the agenda at Border to Coast, a £38bn local government pension pool. “Our portfolio managers, internal and external, consider inflation as one of the many inputs into the investment process,” says deputy chief investment officer Mark Lyons.
While Lyons sees a risk that inflation could become entrenched, he also predicts that economic recession and a slump in consumer spending could act as counteracting, deflationary forces. While all investors face the macro-economic trends of inflation, rising interest rates and recession, the conclusions they draw from them differ significantly depending on the positioning of their portfolios and income requirements.
DB: Taking stock
The need to take stock and assess the damage caused in the autumn is perhaps most urgent among DB schemes, particularly those using a liability-driven investing (LDI) strategy. On the face of it, there is good news. Funding levels have improved dramatically. Schemes in the Pension Protection Fund’s (PPF) universe booked a combined surplus of £374.7bn at the end of October, compared to £103.2bn a year earlier.
Yet it is still early days in assessing the damage of the LDI crisis in terms of asset values. At first glance, the value of assets in the PPF universe grew marginally to £1.49trn from £1.45trn during October. But this seemingly benign trend masks significant differences between schemes.
For example, the BT Pension Scheme’s asset shrank by a reported £11bn during October, accounting for more than a fifth of its assets under management. Others, such as the Royal Mail Pension Scheme, were forced to bring forward their sponsor contributions to mitigate the effect of the liquidity crunch.
At the same time, improved funding ratios mean that talks of the endgame have been dramatically pushed forward and will continue to dominate in 2023, predicts Alan Pickering, president of Best Trustees, an independent trustee services specialist. “I am encouraging all of my schemes to take stock once the dust has settled from the liquidity crisis,” he says. “It is important that employers and trustees get their heads together to review what their objective is. Is it to continue in a steady state, or is to move towards risk transfer via a buyout or a consolidator?
“That means two or three hours with the employer and trustees to take stock of how close they are to buyout or buy-in and what impact that proximity should have on their asset allocation,” he adds. Indeed, the rise in gilt yields means that nearly one in five DB schemes are now fully funded on a buyout basis, with the cost of handing liabilities to an insurer more than halving to £1trn, from £2.3trn in 2021, according to Lane Clark & Peacock. The consultant predicts that demand for buyouts and buy-ins could hit £200bn during the next three years, with £60bn of transactions in 2023 alone.
This would exceed insurer capacity. Alan Pickering, who is also chair of trustees at Clara, predicts that pension consolidators, like Clara, could meet growing demand. In investment terms, rising interest in buyouts means that these schemes will be less inclined to venture into illiquid asset classes.
But on the other side of the DB spectrum, schemes which remain open, such as the local government pools, have, in some ways, benefited from the crisis. For them, diversification into illiquid assets could become increasingly important. This ties into a global trend. More than half of asset owners worldwide (52%) expect to invest more in private markets next year, according to investment consultancy Bfinance.
Open DB schemes have benefited from the fall in liabilities and more favourable exchange rates for overseas investments, Mark Lyons of Border to Coast says. “Thanks to our globally diversified portfolios, where the majority of earnings are from overseas, local government pension scheme funds have tended
to benefit from the fall in sterling,” he adds.
In 2023, Lyons also sees opportunities in bonds. “Higher yields also provide more opportunity to generate income from bonds, and positive real yields on index-linked gilts might even enable some funds to hedge inflation risks. “Investors would be well placed to wait until prices have adjusted to reflect the impact of higher interest rates on the markets. They could also wait until the credibility of the government and Bank of England has been properly restored,” he adds.
But despite these short-term headwinds, Lyons also predicts that the new year will be difficult for open final salary schemes. “The challenge facing local government pension funds is that they will need to adapt their strategic asset allocations to a ‘new normal’ – a more inflationary environment with rising interest rates. “Rising inflation will result in higher pension costs, so generating income will be increasingly important in the coming years,” he adds. “Asset classes such as infrastructure, property, healthcare and higher-income long-term real assets will likely be more attractive to tackle this growing risk. However, it is important to stick to a long-term approach, buying income streams at the best price, rather than reacting to short-term volatility.”
DC: Branching out
Diversification is also the name of the game for defined contribution (DC) funds, which have faced a double whammy of falling equity markets and plunging bond prices, making it bad news for members who are close to retirement. Indeed, many retirement stage default funds are on track to end the year with double-digit losses.
And even default funds in the growth stage are in the red for the first time in years, due to their exposure to US equities. For example, Nest’s 2040 Retirement Stage Default fund is down 7.6%, year-to-date, having reported an annualised total return of more than 7% over the past 10 years. Other growth-oriented DC default funds are also booking losses. Legal & General Investment Management’s Future World Multi-Asset Fund was down more than 11% as of September 2022.
But Maria Nazarova-Doyle, head of pension investments at Scottish Widows, believes bonds remain an opportunity for DC schemes. “At Scottish Widows, we still believe in diversifying the nature of the fixed-income securities we hold across our portfolios, as we observe yields settling into a new range adapted to the new inflationary environment,” she says.
“Indeed, for the first time in many years, we are reviewing opportunities to increase exposure to government bonds in our portfolio. If 2022 has taught us anything, it’s that ‘business as usual’ no longer holds.” Currency risk and the deteriorating outlook for the UK economy are other themes that will dominate her strategy for the year ahead.
As the dollar continues to rise, Scottish Widows is among the investors questioning whether there is a need to hedge currency risks of dollar-denominated assets. “We intend to maintain our structural hedge but are in the process of reviewing its size,” Nazarova-Doyle says. “More outwardly, we are also looking for opportunities to incorporate more global equities into our portfolio, mitigating against the effects of a UK market that will remain defensive for the foreseeable future,” she adds.
DC assets are on track to grow significantly during the next three years, hitting the €850bn (£739bn) mark by 2025, predicts Cerulli Associates, a consultant. At the same time, the share of master trusts within the DC market is on track to double to 40%, up from 17% at the beginning of 2022.
With this growth in scale comes increased opportunity to branch out from traditional DC strategies, which are heavily focussed on passive exposures, to developed market equities.
One example is Nest allocating to private equity for the first time in 2022. It remains to be seen if other master trusts follow suit in 2023. In addition, there is the government’s consultation on broadening investment opportunities for DC. Among the proposals is a move to improve transparency on illiquid assets.
Scottish Widows has participated in the consultation and Nazarova-Doyle describes the steps as “encouraging”. While Scottish Widows’ DC funds are not exposed to infrastructure, she sees opportunities. “These types of investments can improve the overall risk/return profile of DC portfolios and can help increase returns through a illiquidity/complexity premium, while reducing volatility and providing inflation protection, particularly when it comes to infrastructure investments,” she adds.
Insurance: Solvency II revised
The changing economic background is also a key theme for insurance investors. While the LDI crisis has been a challenge on an operational scale, many insurers have benefited from lower bond prices and so have seen the crisis as an opportunity.
This includes Phoenix, which stocked up on government and corporate debt in October. But chief investment officer Mike Eakins acknowledges the scale of the challenges facing investors next year. “We are now in a new interest rate paradigm,” he says. “Twelve months ago, interest rates on 10-year bonds were below 1%, and now they are at 3.5% and that clearly reflects the inflationary environment we find ourselves in and the economic headwinds we face. This will dictate how insurers invest their money.”
Eakins believes that the rise in bond yields will make private markets relatively less attractive. “If you invest in government bonds at 3.5%, then you don’t need to go and shoot the lot out on private markets. Private markets are still a material asset component but at the margin, you will see less demand for private markets.”
All change
Investors from all walks of the institutional market share a sense that 2023 will bring about important changes. With inflation and interest rates set to rise, investors are having to rapidly adapt to a new normal. It is too early to predict which asset classes will benefit and which will lose, but there is already a clear sense that we may see a rotation of actors.
While closed DB schemes are on track to retreat from illiquids to consolidate for their endgame, open schemes could continue to diversify. Meanwhile, rapidly growing DC schemes are also on track to enter new markets. Insurers will have to weigh the prospects of new regulatory incentives to invest in infrastructure and private markets against the appeal of higher returns and liquidity in fixed income. 2023 is set to be a year of changes as investors adapt to a new normal.
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