While this greater focus on liabilities is a broadly positive development, the behaviours it inspires are arguably less welcome because they increase the sensitivity of investors to volatility on both the asset and liability side of the equation. Subsequently, they increase the pressure to think short term and act even where action does not entirely make sense.
GILTY AS CHARGED?
Perhaps the clearest example of how the pressures associated with regulation, accounting standards and career development are increasing the pro-cyclical behaviour of investors is currently taking place in the bond markets.
“Regulatory pressure is pushing funds towards de-risking, which is forcing them to be much less price-sensitive,” according to Tapan Datta, head of asset allocation at Aon Hewitt. “Investors are at risk of a headlong rush into bonds and LDI without taking into account the low yield environment. This kind of pro-cyclical behaviour has risks as it leaves them locked into suppressed yields.”
Datta believes a phased de-risking approach should be considered that takes market conditions into account and potentially speeds up as they improve.
Pension funds’ behaviour in their desire to de-risk is also self-reinforcing as it is a factor in driving yields lower, particularly on long-dated inflation-linked bonds. In turn, that puts liability conscious investors under greater pressure to de-risk regardless of the risks associated with today’s bond prices.
Pension funds are one of the dominant players in the market for long-dated inflationlinked gilts and their behaviour is clearly impacting prices. The gap between yields on fixed and inflation-linked bonds should, in theory, reflect expected inflation.
“Typically, in the UK, the gap is wider than inflation expectations would suggest, partly because of de-risking,” Datta says. “It has been squeezed even more in the last year. Pension funds are typically willing to pay more for inflation protection, which creates a big supply/ demand imbalance. We would have expected it to ease with bonds trading at such high prices, but that is not happening because of the pro-cyclical behaviour.”
Bond yields are generally suppressed because of concerns about the wider economic backdrop, particularly against deflationary pressures. But the danger for de-risking at today’s levels comes if markets are being over- cautious in pushing yields to today’s low levels.
“Some funds don’t care about getting locked into ultra-low yields to get risk off the table,” says Datta. “They are willing to ride the regret risk. However, if the economic pessimism is overdone and yields rise faster than current market expectations, they will be on to a losing strategy. It will become a capital loss issue.
“There is also a danger,” he continues, “that the pro-cyclical behaviour could push yields to the point where there is a more pronounced rise in the future. They are approaching that point now.”
There is another danger associated with this pressure on bond yields. If a situation were to arise where both bond yields and risk asset prices fell in unison, as would result from a significant market correction and subsequent flight to quality, that could create a particularly nasty scenario for many pension funds, especially those who have not completely de-risked, as it would push liabilities up and the same time as asset prices fall.
Importantly, this behaviour is not necessarily a result of poor decision making on the part of those with fiduciary responsibility. It comes as a result of the growing pressure on trustees to minimise funding gaps and the volatility of funding levels through regulation, accounting standards, career risk and other external pressures, but it does require a greater degree of cognisance about what is happening in the market and what constitutes good value.
VALUE AT RISK
It isn’t just external pressure that reinforces the tendency to behave pro-cyclically. Modern investment practice is also at fault.
The widespread adoption of value at risk (VaR) to measure risk of loss on a specific portfolio of financial assets, is another significant factor pushing investors to sell low and buy high.
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