AXA IM Core head of fixed income investment solutions Lionel Pernias and senior portfolio manager Rob Price assess the outlook for credit and pension schemes.
Despite the fall of Liz Truss and her government, we are still feeling the impact of the "mini" Budget that so rattled markets. While the new chancellor Jeremy Hunt has reversed most of the announced measures, he has warned of “eye-watering” difficulties to come when the new Budget is announced.
Instant reaction
The market reaction to the fiscal statement was swift — 30-year-gilt yields increased from before Kwasi Kwarteng’s speech to peak at more than 5 per cent on September 27, levels not seen since the 2008 financial crisis.
It was a tangible shift from classic economic fundamentals to technically driven forced selling. Sterling also fell to as low as $1.03 from around $1.15 in the days before Liz Truss’s appointment, exacerbating collateral calls from currency hedging strategies.
We expect a step change in how pension schemes think about leverage
As markets priced-in deep uncertainty about the future course of the UK economy, there was a dramatic effect on defined benefit pension schemes that were using leveraged liability-driven investment strategies with gilts deployed as collateral for related hedging.
In short, as the value of gilts dropped, they started receiving margin calls from their banks and had to assess rapidly how they would meet those cash demands. The Bank of England saw the risks unfolding and announced a time-limited programme to buy gilts as it sought to offer a steadying hand to the schemes affected — and soothe market concerns more generally.
What followed was a tumultuous period, one that has reminded us that liquidity is a cornerstone of investment and a high-profile test of the resilience of long-term credit allocations in a moment of market stress.
Credit where it is due
The long-term impact for many pension schemes as well as the makeup of LDI as we knew it is yet to be seen.
However, as the dust settles, our early observation is that we think this crisis has helped emphasise the potential importance of credit for UK pension schemes.
The swift reversal of significant parts of the package has indeed stabilised conditions, and, at the moment, credit feels like a good two-way market, especially for schemes. Some are consolidating and reviewing their collateral positioning, perhaps looking to raise funds from credit.
Credit may also appear relatively attractive right now in terms of valuation and spread, conditions that are pushing some schemes to opportunistically add credit, sometimes using collateral that was raised and is no longer needed. Other schemes are exiting less liquid asset classes and using those flows to increase credit allocation.
Over the longer term, we continue to see fundamental benefits of credit for pension schemes and expect many of those benefits to be bolstered in the aftermath of this crisis.
Cash flow delivery to pay pensions is a given, of course, but the potential liquidity and spread advantages have been underscored by recent events. The same is true, we believe, of that potential hedging capability of well-managed, long-term credit allocations.
Importantly, we have now seen confirmation that credit can provide liquidity as needed at times of painful market stress as well as in more normal conditions. As schemes look ahead to their longer-term objectives and potentially a buyout, this experience may be useful.
Meanwhile, the market outlook for long-term sterling credit portfolios has improved significantly, in our view, even though it has been a very rocky road to get there.
Credit fundamentals in general may well have seen a deterioration, but we believe careful, active management should be able to reveal potential upsides in high-quality, selected names.
One observation we have made is that credit has moved from what was quite a tight market with more buyers than sellers to a fundamentally wide market within which pension schemes may be well rewarded for taking on extra risk, in our view.
Returns, after all, are needed to close deficits and meet payments over the longer term, and credit’s prospective return over gilts is clearly attractive at this point.
As we look ahead, we expect a step change in how pension schemes think about leverage following this sharp reminder of its role in so many crises.
At its simplest, we think LDI leverage will have to come down and that schemes will have to look instead at asset classes that can provide an effective hedging alternative.
Our experience over the past couple of months has indicated that long-dated credit could potentially form part of that solution.
Lionel Pernias is head of fixed income investment solutions at AXA IM Core. Rob Price is senior portfolio manager at AXA IM Core.
