These are exceptionally challenging times for fixed-income investors. The nervousness that has characterized the markets since the downturn of 2007/08 shows no signs of abating. Policymakers are still struggling to turn the tide. The capital markets remain fragile. And as the consequences of the crisis continue to ripple across the globe, old certainties are being rapidly eroded.
Meanwhile, investors must grapple with the immediate consequences of attempts by the world's central banks to contain the economic crisis. Thanks to quantitative easing, both short- and long-term interest rates remain under pressure across developed markets. In the U.S., many wonder if the impact of the upcoming "fiscal cliff" will kill off the still-tentative recovery and prompt a double-dip recession. And the elusiveness of a durable solution to the continuing turmoil in Europe is prompting widespread fears that the contagion from the sovereign debt and banking crises in that continent's periphery nations will spread to its center and beyond, infecting the broader global economy.
But if "worry" remains the market watchword, a significant number of fixed-income investors are also seeking— and identifying—new strategies to cope with persistently low interest rates and enduring economic uncertainty. Their core challenge, as Jesse L. Fogarty, Managing Director and Senior Portfolio Manager at Cutwater Asset Management, puts it: "To get some yield in a noyield world".
In today's low-rate environment, many plan sponsors have put liability driven investing (LDI) on hold. Yet many remain concerned about duration. And despite the challenges, some are continuing the derisking process with a phased approach
Today's markets are challenging all manner of investment beliefs and strategies and few moreso than managing pension-funding volatility by extending duration as part of an overall commitment to liability driven investing (LDI). With rates so low, and likely to remain under pressure for some time to come, many plan sponsors have postponed their derisking strategies, which often hinge on glidepaths tied to specific funding level targets or interest- rate triggers.
Such attitudes are understandable. "There were LDI inquiries from clients in prior years, but we are hearing less of that recently, particularly with long–end rates below 3%," remarks Thomas O'Connor, Senior Portfolio Manager of the Wells Fargo Advantage Total Return Bond Fund. And Krishna Memani, Director of Fixed Income, and Senior Vice President and Portfolio Manager at Oppenheimer Funds, agrees. "Your primary objective with LDI is certainty," he says. "You want to minimize residual risk. But the likelihood is that you won't be able to do that in a workable format. It just isn't feasible in this yield environment. You need income streams to make it work. And there are not enough securities at 7% to 8% rates out there in large enough sizes to satisfy LDI demand."
With the Eurozone in turmoil and growing doubts about the sustainability of growth rates in some key emerging markets, U.S. fixed-income investors may be forgiven for wondering if the internationalization of their portfolios is such a good idea. Managers, however, continue to find opportunities as markets diverge.
Time was when developments in international bond markets were of peripheral interest to U.S. fixed-income investors. No longer. The sovereign debt and banking crises in Europe are now front and center stage. And the ongoing failure to resolve them has everyone worried.
The issues in Europe are complex indeed and changing almost daily as concerns about the resilience of peripheral Eurozone countries like Greece and Ireland spread to the continent's larger economies, Spain and Italy among them. "Even core countries like France are impacted," remarks Thomas O'Connor, Senior Portfolio Manager of the Wells Fargo Advantage Total Return Bond Fund.
Attempts to de-leverage the U.S. economy have somewhat distorted the fixed income markets. But, say managers, the case for pension plan de-risking remains sound
U.S. policymakers and the Federal Reserve have been busy. The Fed, through quantitative easing and the policy known as Operation Twist—buying and selling short-and long-term bonds—has been trying, with some success, to hold down the long end of the yield curve. As a result, they have increased investors' appetite for risk—and confronted them with some complex choices.
Should they take on credit risk in the high-yield market, for example? Or are structured products the way to go? And, they increasingly wonder, how much longer can monetary policy alone bear the burden of de-leveraging the U.S. economy? "Monetary policy is a bit like penicillin shots," observes David R. Wilson, Managing Director, Customized Strategies, at Cutwater Asset Management. "The more you get, the less effective they become. And we've had a lot of shots recently."
For pension plan sponsors looking to extend duration, managers argue that long corporates are a good buy—especially relative to swaps
U.S. pension plans have been slow to adopt liability driven investing (LDI)—thanks largely, of course, to historically low interest rates. Yet even in the present environment many recognize that managing pension-funding volatility by extending duration, if only gradually, can help minimize residual risk. In the past, after all, plans have missed plentiful opportunities to de-risk; and back then their funding levels were a lot healthier. While timing the window of opportunity remains tricky, no one wants to be caught out again.
Managers, indeed, report that more plans are expressing interest in extending duration to match their liabilities—and that many aim to achieve that goal by extending the duration of the corporate bonds in their portfolios.
There are, to be sure, concerns about the long-term availability of U.S. dollar-denominated long duration bonds—research by Cutwater Asset Management, for example, estimates a potential US$700 billion shortfall between supply and demand. Nevertheless, as part of a carefully considered and phased de-risking strategy, long corporate bonds remain an attractive option.