Coping With Low Bond Returns

Low SignEuropean pension funds are shifting their fixed income allocations away from traditional benchmarked funds and towards fixed- income solutions, such as smart beta, said Andy Howse, head of Institutional at Pyramis Global Advisors. He was speaking at the 2015 Investment Innovation Conference held at the Terranea Resort in California last October. During his presentation, titled “Income or outcome: the evolution of active bond strategies through the lens of European pension funds,” he explained that bond returns have been strong across the board due to factors like falling inflation and yields. In this environment, beta has been the main driver of bond returns. That factor has boosted performance for all fixed income managers, regardless of skill or ability to generate alpha.

But as Howse noted, conditions are changing – fast. “The strong market for bonds has bailed out active managers because total returns have never looked so good,” he said, adding that “this is unlikely to happen again as we roll forward.”

Indeed, the bond market is undergoing a significant shift
– bond returns will vary in future but they’ll be much lower as economic recovery continues, inflation trends upward, and central banks begin to normalize rates.

Together these factors will exert pressure on active managers to justify the fees they charge as investors begin to look closely at returns and where they’re coming from, both alpha and beta.

Pension funding in Europe

Howse explained that this challenging investment environment has prompted significant changes in portfolio construction among European pension plans, many of which are seeking to de-risk through glide paths that clearly separate alpha and beta. With
the focus now on funding levels and risks management, plans are seeking outcome-based management as opposed to traditional, benchmarked active portfolios.

But what does that mean for fixed income? Right now, Howse explained, plan sponsors must rethink their bond allocations and consider total and absolute return solutions. These have two major advantages: they are unconstrained by benchmarks and can be a better fit with the objectives of a specific plan.

One emerging tool in the fixed income toolkit is smart beta. While plan sponsors are already likely familiar with its uses in the context of an equity portfolio, smart beta can also be applied to bonds noted Howse. Smart beta seeks to capture investment factors or market efficiencies in a smarter way for better risk- adjusted returns. It also works to emphasize factors that have historically been rewarded by the market – i.e., volatility and momentum.

In the case of fixed income, Howse explained that a smart beta approach leads to better investment outcomes in some areas of the bond universe, particularly global high yield. He presented research that shows it can reduce regional skew and improve diversification, generating superior returns based on historical data.

Smart beta is certainly something for plan sponsors to consider, especially as portfolios come under increasing pressure in a rising rate environment. Plan sponsors will need the broadest possible toolkit to navigate a challenging and complex fixed income space.