The bond/equity timing gamble

Traditional wisdom has it that bonds are the place to be when bears stalk the markets. Paul Farrow asks whether DC scheme members should be advised to move out of equities too

When stock markets falter investors rush for the sanctuary of bonds. At least they used to until the credit crunch came in to town.

But the market problems have hit many core pensions assets. Just as equities and commercial property have been blitzed by the financial crisis so too have bonds. It seems that unless you have been invested in commodities and gold you will have come unstuck.

Over the past two years bonds have not made a bean, while even over three years they have not been worth a whole lot more – the average ABI corporate bond pension fund has fallen by 1.2 per cent. Over the past three years the typical return has been a dismal 0.6 per cent.

But there could be light at the end of the tunnel – history suggests that bond markets recover before equity markets and many reckon that the worst is over for the credit sector. Unlike many fund managers, those that run bond funds tend to be frank with their opinions. If they are thinking gloomy thoughts they will not try and spin their way out, unlike many of their equity counterparts.

It was not that long ago that bond managers were admitting that bonds were a waste of time and that savers would be better off in a deposit account at their local high-street bank or building society. Stephen Snowden, the Old Mutual fixed interest star, once proclaimed people would be better investing in an ING Direct account. He was right – they would have been, even though the ING account was no longer a best buy.

But there has been a sea change. The shift in sentiment – particularly in the loss of confidence in the banks – has caused bond prices to fall and yields to rise. Spreads on corporate bonds have been falling back to levels not seen for five years and fund managers have been picking up bargains, particularly among the banking sector. During the past year, credit markets have priced in a lot of sub-prime related losses, considerably more so than equities. Investment grade spreads now take into account five times the last worst period for default rates in 1984.

“Corporate bonds have come down to levels where many of them now represent potential great long-term value. For this reason we would not be surprised to see pension funds increase their bond allocations,” says Stephen Snowden, manager of the Old Mutual Corporate Bond Fund. “From a historical perspective, bonds have tended to change direction before equities and we know that the current bear market is over one year old. The precise timing of the next bond market recovery is impossible to predict but for investors it generally pays off to rely on a dynamic, rather than passive, asset allocation.

John Patullo, manager of the Henderson Preference & Bond and Strategic Bond funds, was also one of the bond bears but he now believes that investors should be thinking about increasing their bond allocation.

“We’ve been saying this since Bear Stearns. It’s a good time to be moving into corporate bonds – the risk/return profile is positive. Bonds will be the place to be. It’s a great opportunity. A lot of the problems in them have gone away. A lot of leveraged investors held a lot of bonds and got washed out. We’ve moved from a financial crisis into an economic recession – from Wall Street to Main Street. The bond market has already capitulated, but we haven’t yet seen equity markets capitulate. We do hear there will be more asset allocation flows from equities into bonds. They offer a good risk-adjusted return.”

In the institutional sector the move towards bonds has already been made. Overall, the average pension scheme asset allocation to bonds has increased from 35 per cent to 40 per cent in just 12 months. This represents the largest 12-month shift in investment strategy for 20 years.

UK pension schemes have channelled more than £18 billion into bonds, according to analysis by consultants Pension Capital Strategies. Admittedly some of the shift is down to pension funds’ need to de-risk their portfolios to match liabilities but there is also the need to manage funds during, what many experts see as a prolonged downturn.

Daniel Peters, investment consultant and actuary at Aon (whose own survey showed that half of FS pension fund shifted from equities into bonds during the past 12 months) says he is not surprised. “It’s no surprise that as pension schemes mature and trustees become increasingly risk aware, nearly half have moved some part of their growth portfolio into matching assets.”

Mark Jaffray, senior investment consultant at Hymans Robertson LLP, says: “A number of DB schemes made switches from equities to bonds in the summer of 2007 when the “nirvana” of rising equity markets and rising bonds yields made this switch particularly attractive. However, many regret they did not make this move; they are now suffering significantly reduced funding levels. Many schemes have now put their planned switches on hold until the direction of markets becomes clearer and the switching terms become more attractive.”

But should GPP and group stakeholder members follow the institutions’ lead? Experts say that much will depend on the age of the individual member and the funds in which they are currently invested.

“The investment of funds to cover liabilities under a final salary pension scheme is different to that which applies for individuals with trust-based DC or GPP’s. In the former, the scheme trustees would take guidance from the actuaries as to an appropriate asset allocation to meet the liabilities of the scheme,” says Lee Smythe at Killik & Co. “In the latter, individuals and their advisers need to take account of attitude to risk as well as duration until retirement in making suitable investment decisions. The asset allocation will be the main driver of returns, rather than the individual fund performance.”

But Hewitt reckons that today the right thing to do is to reduce clients’ equity exposure – whether you are in a DB or a DC arrangement. “We have been cutting our equity exposure for the past year,” says Colin Robertson. “We prefer the shorter-duration bonds – 10 to 15 year gilts are much better than those of 50 years. We are not keen on high yield corporate bonds because they are very linked to the economy and a recession will be bad news for the sector. But you should have some exposure to investment grade corporate bonds.”

The age profile of the employee is a key factor. Many members of DC schemes are relatively young; they should therefore be able to ride out near term volatility in equity markets. Further, they need to consider how their existing investment relates to the amount they will expect to contribute over the remainder of their working lifetime. Even for a 40 year-old, future contributions will be very significant relative to the amount already invested. The individual is likely to have over 20 years in which to see equities recover before they will be drawing their pension.

The problem of timing the market is a perennial one for GPP members. Even if they had made the switch – and the arguments are that those looking to benefit from any bond upswing should have made the move already – there will come a time when they should increase their exposure to equities. Leave it too late and they might find their pension pot is not quite the sum they thought. Besides, evidence suggests that very few people within DC schemes actively switch between funds – figures indicate that this percentage is in low single figures.

The dilemma is increased by the prospect of inflation – which does not tend to be good news for bonds. RPI is at 5 per cent and matches base rate for the first time since 1981. Again the jury is out on whether it will be a prolonged period of inflation or whether it will be nipped in the bud.

“Bond prices are still low, and have been kept under pressure over the past few months by inflationary concerns, which in turn spurred expectations for a short term upward move in interest rates,” says Snowden. “However, we believe UK interest rates will come down considerably over the next 12 months and that should benefit bond markets. Rising inflation, which currently underpins interest rate expectations, is unlikely to remain a threat for long as it is driven by external supply issues rather than domestic demand which actually continue to fall in the economic downturn.”

But while bond managers such as Snowden don’t believe inflation will be an ongoing problem, the events of the past year have wrong-footed many an expert. Few forecast the credit crunch – or how long it would last. It is now a year old and the ramifications are there for all to see – there are few smiles on the faces of economists.

“Of course, what we are all hoping for is enough money in retirement to maintain a certain living standard and, therefore, how much money we will ultimately need is dependent on inflation. The typical bond does not offer any inflation protection and therefore is also a potentially risky pension investment. With British Government gilts yielding less than 5 per cent, the real return could be very low (and potentially even negative) if we suffer continued high inflation,” says Winter. “Index linked bonds do offer inflation protection and yet the low yields on long dated index linked gilts mean that investors can expect a real return of less than 1 per cent a year, making them an unattractive investment proposition for most people saving for their retirement.”

The safety net for employees is that they invest on a monthly basis, thereby taking much of the timing risk out of the equation – equities maybe jittery but they are buying shares at lower prices (therefore buying more units) all the while markets fall. They will benefit when markets recover.

Jaffray reckons the key message is that companies have different priorities from members of GPP and stakeholder schemes. He suggests that members who have a significant amount of time until retirement would be advised to sit tight. “They will see volatility in their assets, but they will also benefit from pound cost averaging, currently buying units at depressed prices,” he says.

Smythe agrees with Jaffray that there should therefore be no real case for a wholesale movement to corporate bonds for the younger generations if they are some way from retirement. “As timescales reduce then more secure investments should indeed be considered, although in the current climate corporate debt compared to gilts may still be a risk to far for those close to retirement.”

It may be a blessing in disguise for the majority of older employees that by default they are in a lifestyle fund – for them the timing of the switch from equities to bonds might just be not far off the mark.

expert view

Natalie Winter, client director, Aberdeen Asset Management

Natalie Winter, client director of Aberdeen Asset Management and chair of the Society of Pension Consultants’ investment committee, says: “The equity markets have fallen in 2008 in recognition of the expectation of a slowdown and the recession risks the economy now faces. With the benefit of perfect hindsight, of course, pension scheme members may regret not having switched out of equities last year – but market timing is a difficult game.”

Winter poignantly notes that many institutional fund managers fail to add value consistently by timing switches between equities and bonds, despite the depth of resources at their disposal. “If the highest paid financial professionals can get their market timing wrong then what chance does the typical pension scheme member have?” she asks. “Indeed, assuming that pension savers do not have any better insight into financial markets than other investors, actively managing their asset allocation in this way may only lead to a reduced pension pot as their return is eroded by the transaction costs incurred in switching between
markets.”