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The Actuary The magazine of the Institute & Faculty of Actuaries
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High interest in fixed income

Fixed income as an asset class has traditionally been viewed as the poor relation to equities. For many observers, the need to invest in fixed income at all has been beyond their comprehension after all, equities give a better total return, given a long enough time horizon.
But times are changing and fixed income is increasingly being seen as a key asset class in the realms of matching assets to liabilities. Within fixed income, the corporate bond is rapidly gaining recognition as an asset class in its own right. From a fund management perspective there has been a significant expansion in the size of many fixed income teams, with the job market for corporate bond specialists being particularly hot.
But what has changed? And why are corporate bonds being talked about so much?.

The demand case for fixed income for pension funds
The long-term case for equity investment within pension funds is clear, but economic value arguments will be outweighed by the reporting benefits of better matching liabilities (ie switching equity to fixed income), especially for more mature defined benefit schemes.
Traditionally, defined benefit pension schemes have been mismatched in terms of holding far more equities than the underlying liabilities would justify. However, a number of schemes have had to confront the implications of the minimum funding requirement (MFR). The formulation of the MFR implies that a fund is likely to hold a rising proportion of gilts as its members age. At the end of the day the MFR will result in pension schemes reducing their asset-liability mismatches, beefing up their need for long sterling bonds.
The accounting profession (ASB) has reviewed the workings of SSAP24 with a recently published exposure draft (FRED20) which recommends that pension liabilities be discounted at the rate of AA corporate bonds, and advocates a market-value based approach for accounting for pension costs.
When established as standard accounting practice, the new approach will ultimately make more transparent the costs associated with providing guaranteed benefits and will highlight how these costs vary according to changing financial conditions. For more mature pension schemes in particular, a more matched asset-liability profile will help reduce volatility in the accounting of these pension costs.

The demand case for fixed income for life insurance funds
As interest rates have fallen, investors have switched to funds offering attractive guaranteed returns and this has resulted in spectacular sales of with-profit bonds for life companies, although many have become the victims of their own success.
The free asset ratios of many life companies have slipped below 10% as a result of factors such as:
– pensions miss-selling costs;
– setting up reserves for guaranteed annuities options;
– new business strain from putting the with-profits business on the books.
This is further compounded by the fact that liabilities are discounted at the current low yields available on underlying assets and are as a result higher for regulatory valuation purposes only the dividend yield can be used for equities, and a lot of the underlying with-profits funds have an 80/20 equity to fixed income split.
Improvements in mortality have resulted in the need to invest in higher yielding assets than gilts to back annuity business written before the improvements were apparent .
Insurance companies are no strangers to corporate bonds, with some having been investors in this market for a number of years. But the size of this investment has grown rapidly as, to increase the regulatory discount rate, insurance companies have switched into fixed income investments in a chase for higher yield, and into corporate bonds in particular. It is estimated that a typical with-profits asset pool could be 50/50 equity to fixed income by the end of this decade. However, there are also risks in investing in this asset class and a strong fund management capability is vital.

The supply case for fixed income
On the supply side, the government’s finances swung into surplus in late 1997 and the volume of gilt issuance has fallen just at a time when demand is rising sharply, and is likely to remain strong for structural reasons. A distortion is already evident: long gilt yields are about 150 basis points below corresponding German yields.
At the same time, the sterling non-gilt bond market is experiencing unprecedented issuance. The drivers for this issuance are threefold:
– Issuance of debt allows a company to improve its leverage and can facilitate some financial engineering such as buying back shares to improve its return on equity.
– Acquisitions and mergers are accelerating as the European business marketplace becomes more open a war chest is essential if companies are to compete and survive.
– Seeking debt from the capital markets has become a must for some companies as their traditional sources of finance (mainly banks) have closed their doors to them or are charging unattractive rates.
In summary, large supply and strong demand is a win-win situation for corporate bonds and will have an impact on resources needed by fixed interest teams.

Corporate bonds return and risk considerations
All bonds, including government, are credit-rated. Credit ratings reflect the ability and willingness of the issuer to make full and timely payment of both coupon and principal. For example consider the UK 2009 gilt which has the highest Standard and Poor’s rating of AAA: if bought in the market and held to redemption, the series of coupon payments and repayment of principal would give an annualised return of 5.53% (at 1 February 2000).
But other AAA sterling bonds are available that give a higher redemption yield. For example, the European Investment Bank has a bond issue of the same maturity as the 2009 gilt as well as the same rating of AAA, yet it still yields an extra 0.49% per year in terms of yield to redemption yield over the 2009 government gilt. As the rating becomes lower for the other bonds of the same maturity, the extra yield available over the government gilt increases. As examples, the Prudential 2009 bond (AA rated) gives an extra 0.79% per year and BSkyB 2009 (rated BB+) a thumping 2.75 % of additional annual yield . This extra yield is commonly referred to as the credit spread.
There has been much recent comment about default risks on corporate bonds, so the question we must answer is, ‘does the extra yield compensate for the increased risk of default on repayments?’. Using historical default and recovery rates based on US data, it is possible to impute a theoretical extra yield premium to pay for default risk. These theoretical premiums are far less than the actual premiums available in the market for bonds held to redemption, so clearly there are other risks than default risk alone.
Portfolio managers of active credit fixed income portfolios are exposed to credit spread widening risk on a daily basis, and widening credit spreads broadly relate to underperformance versus gilts, so fund managers are especially wary of this happening. However, credit spreads can widen sharply even when ratings on companies have not changed, ie there is not necessarily a correlation between rating changes and spread moves.
A corporate bond issuer may typically have a number of issues in existence at any one time, of varying maturity dates and coupon payments. Credit spreads for an issuer are not uniform across issues of different maturities and indeed spread dynamics can vary according to issuer circumstances. For example consider Lloyds TSB since the financial crisis in mid-October 1998 (when credit spread levels moved out sharply on Lloyds TSB bonds of all maturities), credit spread levels have come in markedly, with the clear exception of bonds whose maturities are 20 years away or more. Why is this? Well, in 1999 Lloyds announced its purchase of Scottish Widows. While this story was a positive for the equity market, because Lloyds was expected to issue large tranches of long-dated paper to finance this transaction, credit spreads stayed out wide. Conclusion: credit spreads are a function of both time and duration.

Looking ahead
Fixed income investment is continuing to attract new supporters, as its value becomes more widely appreciated within the UK. The US fixed income market is considerably more developed than that of the UK and has led to major new investment classes, such as asset-backed securities, combined debt obligations, and private placements. These classes have different risk/return attributes to meet the needs of a wide class of investors. UK fixed income is likely to mirror these developments, with a consequent requirement to analyse these instruments. Fixed income teams of tomorrow will look a lot different from those of today.

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