Insights A solution to the pension conundrum? With global bond yields near record lows, convertible bonds can offer pension fund investors a less volatile alternative to equities, while maintaining exposure to global growth. September 2014 Following the appreciation of global equity markets over the past five years, the overall funding gap for pension funds, i.e. the difference between assets and future liabilities, has narrowed significantly and we have noted a large number are now reviewing their asset allocation policy. However, with global bond yields near record lows and equities lacking the desired capital protection characteristics, many are now looking to the convertibles market as a way to maintain exposure to global growth, but with the added protection of a fixed income product. Pension fund mangers decisions today will impact the future global economy From the latest available data, as of the end of 2013 total global pension fund assets were approximately US$31,980 billion. Over 95% of these assets are held in just seven countries: Australia, Canada, Japan, Netherlands, Switzerland, UK and US. These are known collectively as the P7 (Fig 1). The total value of the assets in these funds represents around 106% of the GDP of their collective economies, individually ranging from 65% in Japan to 131% in the UK. The total GDP of the P7 countries equates to 75% of global GDP. Thus it is clear that the management and performance of these assets could have a significant impact on the global economy. With populations ageing in developed nations, the wealth of retired citizens will have a considerable bearing on consumer spending patterns. As a result, the decisions pension fund managers make today could materially affect the future performance of the global economy. Fig. 1 Global pension fund assets by country (the P7 ) At a glance A convertible bond is a fixed income instrument which the holder may exchange for a fixed number of shares Convertibles generally pay a fixed coupon and are normally issued and redeemed at 100% (their par value) They offer low-volatility exposure to equity upside in addition to attractive credit spreads and lower duration risk than conventional bonds Historically, convertibles have produced positive returns when government bonds suffered significant losses due to rising interest rates Canada 5% Australia 5% Japan 11% Netherlands 4% Switzerland 2% Due to their hybrid nature, convertibles can appeal to a wide range of buyers UK 11% US 62% Data source: Towers Watson, as at 31 December 2013 Page 1
The onset of the financial crisis caused global equity markets to suffer heavy losses and bond yields to fall. Although the value of the bonds held within pension fund portfolios rose as interest rates fell, the significant fall in global equity markets resulted in an overall loss of the value of assets held. Liabilities, however, grew substantially as the falling discount rate precipitated a rise in the present value of future liabilities. The sudden widening of the funding gap led to a particularly toxic situation for pension funds, leaving many severely underfunded. With interest rates remaining low and longevity increasing, the liability side of the balance sheet has continued to grow, although the recovery in equity prices has helped close this funding gap somewhat. This situation has led to a review of asset allocation policy and now poses the question: should pension funds reduce their allocation to equities to lock in gains? Although this would reduce the risk of exposure to a fall in equity prices by increasing the allocation to fixed income, it would also lock funds into low-yielding assets at a time when global interest rates could be about to rise. We believe convertible bonds offer pension funds the opportunity to maintain exposure to the growth potential of equities with the capital protection properties of corporate bonds and a lower duration risk than standard fixed income instruments. Currently more than 50% of total worldwide pension fund assets are invested in equities. The remainder is split between fixed income at roughly 30% and alternative areas such as hedge funds, property and private equity at around 20%. (Fig 2). Should pension funds reduce their allocation to equities to lock in gains? Fig. 2 Global pension fund assets by asset split 100% Percentage of assets Data source: Towers Watson, as at 31 December 2013 Although global equity markets appear to have fully recovered from the financial crisis with prices at all-time highs, pension funds collectively remain underfunded. If this situation persists, it will create a drag on economies from multiple angles in the coming years. In the case of defined benefit (DB) schemes, companies or governments could be forced to raise contributions to close the funding gap. For some companies, this funding gap could lead to lower profitability, reduced dividends and, in extreme cases, bankruptcy. For governments, a greater share of future tax income could be diverted to pension payments, leading to increased debt levels and, in effect, a tax on the current working population to fund retirees. Individuals in defined contribution (DC) schemes may either have to increase their contributions now to maintain their desired level of retirement income or accept a lower pay-out in the future. Either way their disposable income would be reduced; if not today then upon retirement. Why do pension schemes remain underfunded? Despite the rise in the values of global pension fund assets, which are estimated to have increased by 9.5% in 2013, liabilities have also grown considerably at a compound annual growth rate (CAGR) of 6.7% over the past ten years. This is due Page 2
to two factors: firstly, increasing life expectancy has required pensions to be paid for longer; and secondly, depressed government bond yields have lowered the rate at which liabilities are discounted leading to a higher net present value of those liabilities. Over the last decade pension funds have experienced high levels of volatility in their asset/liability balance. (Fig 3). Fig. 3 Increased volatility in pension fund asset/liability balance Pension funds as a whole remain underfunded Data source: Towers Watson, as at 31 December 2013 The appreciation of global equity markets from 2005 to 2007 improved funding positions as the rise in pension fund asset values exceeded the growth in liabilities. Several pension funds actually used this as an opportunity to stop contributing to company schemes, taking a pension holiday. However, the financial crisis of 2008 caused a dramatic reversal and many funds found themselves in deficit. Equities subsequently rallied and companies have increased contributions, helping reduce the asset/liability mismatch. As interest rates rose in 2013, liabilities fell due to a higher discount rate. This fall, combined with further rises in equity values, led to the asset/liability indicator reducing the gap but as a whole pension funds remain underfunded. How are pension funds addressing the shortfall? Although many global pension funds remain underfunded, they are clearly not a homogenous group. Funding positions vary considerably across the many thousands of existing individual schemes, and different courses of action will be required. 1) Fully funded schemes: when the assets of a fund exceed the liabilities it would be logical to de-risk the portfolio. This would protect against potential future impairment of the value of the assets in order to ensure they are sufficient to meet future pension payments. This will probably require a much higher allocation to fixed income products as opposed to equities, which are more volatile. 2) Underfunded schemes: pension funds suffering from a current asset valuation below calculated future liabilities face a conundrum in today s investment climate. Many will have reduced the gap in recent years thanks to the strong rally in global equity markets and the rise in government bond yields from the lows of 2012. However, going forward we anticipate they will probably reduce their exposure to equities, given their associated volatility, and poor riskweighted returns. If equity prices were to fall again this could lead to a drop in asset values and a new widening of the funding gap. Unfortunately, a switch into core government bonds at current yields will lock in low levels of income and expose pension funds to potential mark-to-market losses should interest rates rise in the medium term. Central banks in Europe, Japan and the US are all targeting higher inflation than prevailing levels and the risk of real inflationadjusted losses in core government bonds at current prices is substantial. A switch into corporate bonds may offer a potential solution to funds that have a small funding gap, but high-grade corporate bonds currently offer little extra Page 3
income over government bonds with non-financial investment grade bonds yielding only 1.0% in Europe and 1.8% in the US. Sub-investment grade bonds, although they carry a greater risk of default related losses, are also being considered by some funds. However, although they offer greater income (Europe 4.2% and US 5.8%) investors should be conscious of the near cyclical low premiums that investors are receiving for taking on the higher default risk associated with such issuers. In addition, if benchmark interest rates do increase, then the value of high yield bonds may prove less resilient than in previous cycles. This is due to the very low current nominal coupon rates and consequent longer duration. Finally, private equity funds and hedge funds may offer alternative solutions, but both can follow a wide range of strategies with varying performance. Also their high fee structures are attracting greater attention from investors in an era of low nominal returns. Convertibles offer investors the ability to participate in the potential upside of a company s shares, but with lower volatility Can convertible bonds provide a solution? As hybrid instruments, convertible bonds perform very differently to cash equity or fixed income. Convertibles offer investors the ability to participate in the potential upside of a company s shares, but with considerably lower volatility. This is due to their fixed income qualities and higher rank in the capital structure than equities. With a fixed coupon and defined redemption schedule, convertibles are not subject to the vagaries of dividend payouts or indefinite timeframes associated with equity investment. They also generally rank pari-passu with unsecured corporate fixed income instruments. Historically convertibles have exhibited less than half the volatility of equities and over the past fifteen years, have actually outperformed the global equity index (Fig 4). Fig. 4 Convertibles have outperformed equities Rebased to 100 275 250 225 200 175 150 125 100 75 Thomson Reuters Global Focus Conver ble Bond Index MSCI World Equity Index 50 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Data source: Thomson Reuters Convertibles Marketing / MACE, as at 31 August 2014 Notes: Comparative Index Performance (Rebased to 100) This has led to convertibles having a much better risk/reward profile as calculated by the Sharpe ratio (Fig 5). Fig. 5 Convertibles offer lower volatility than equities Index Vola lity Sharpe Ra o Thomson Reuters Convert Bond 8.0% 0.35 MSCI World Equity Index 16.8% 0.05 Data source: Thomson Reuters Convertibles Marketing / MACE, as at 31 August 2014 Notes: Statistical Metrics from 30 June 1998 to 31 August 2014 Page 4
This leads us to believe convertibles can be seen as a means for pension funds to maintain an allocation to their growth bucket whilst concurrently reducing overall portfolio volatility. Can convertibles replace a portion of pension funds fixed income exposure? In today s environment of exceptionally low interest rates, the potential returns on core fixed income portfolios are becoming increasingly asymmetric, in our view to the detriment of investors. Central banks have been targeting lower inflation since the 1980s and, in the wake of the 2008 financial crisis, launched programmes of quantitative easing. This helped fixed income investors to enjoy a more or less uninterrupted bull market. With inflation now running below official targets, central bankers appear more focused on the disinflationary impact on consumers and companies. Higher inflation rates would also be beneficial to countries such as Japan, the UK and US and in the eurozone, where a bout of inflation would decrease the real value of debt in these heavily leveraged economies. Convertibles can be seen as a means for pension funds to maintain an allocation to their growth bucket However, the main objective of the liquidity measures introduced by major central banks over the past five years has been to stimulate growth to the point where inflation has become a secondary consideration and possibly a necessary evil to be tolerated if renewed economic growth is to be achieved. Thus it is highly likely in this cycle that central banks will tolerate being behind the curve in raising interest rates to curb a rise in general price levels. This has serious implications for fixed income investors who could witness the real value of their investments eroded by inflation, without the necessary coupon income to compensate for losses. Although convertibles are fixed income instruments, their behaviour in periods of rising interest rates has historically been counterintuitive. In the previous four cycles, when rising rates inflicted losses of greater than 5% in a single calendar year on core fixed income portfilios, global convertible bond returns have been positive and produced double-digit returns in three of these periods (Fig 6). The explanation for this counterintuitive behaviour for a fixed income instrument lies in the reason behind the rise in interest rates in those years; the improvement in economic growth led to a normalisation of rates. The expansion in economic activity was beneficial to corporate profitability, which in turn led to rises in equity markets and tightening credit spreads. Although the pure fixed income element of a convertible bond is sensitive to interest rates in the same manner as a straight bond, the rising value of the equity component, and the improvement in credit spreads, outweighed the duration-related losses. This subsequently allowed convertible investors to register gains. Fig. 6 Convertibles have outperformed government bonds in a rising rate environment 30% 25% Government Bonds Conver ble Bonds 20% 15% (%) 10% 5% 0% -5% -10% 1994 1999 2009 2013 Data source: Bloomberg as at 31 December 2013 Note: Based on the last 20 years when government bonds have posted losses greater than 5% Therefore, in our view, it appears to make sense for a portion of a portfolio s fixed income exposure to be dedicated to convertibles. This will allow the portfolio to benefit from diversification and improve the overall risk/return ratios. Page 5
Do convertibles offer an investable universe? The convertible universe offers a broad spectrum of investment opportunities across all regions and credit ratings (Fig. 7). The vast majority of issuance (around 90% of total outstanding debt) is denominated in either US dollars, Japanese yen or euros. Recently there has been an increase in demand for bonds issued in several Asian currencies, including the Chinese renminbi, Hong Kong dollar and Singapore dollar. However this segment is small, and currently makes up only 6% of the total market. Fig. 7 Breakdown of the convertible bonds investible universe US 30.31% Asia ex Japan 14.66% B 10.91% CCC 1.60% AAA 0.77% AA 1.36% A 22.39% offer a potential solution Japan 8.70% Europe 46.33% BB 32.67% Data source: Thomson Reuters Global Focus Index, as at August 2014 BBB 30.30% Issuing companies range from household names such as Adidas, Intel and Sony to high-growth mid-cap companies across the globe. Issuers use the product as an alternative form of finance to straight debt or equity as it carries a lower coupon than straight debt and is less dilutive than pure equity. The current estimated size of the market is approximately US$500 billion with around 2,000 issuers. The current annual rate of primary issuance is US$100 billion, which brings a steady flow of new opportunities and more balanced profile bonds to the market to replace expiring issues. Liquidity is comparable to ordinary corporate bonds of similar credit ratings; the majority of transactions are handled in the over-thecounter market by investment banks, although most issues are listed on recognised stock exchanges. Price transparency is good, with several leading data providers offering daily pricing services. There are a number of global index providers including Jeffries, Bank of America and Thomson-Reuters. Although there is an Exchange Traded Fund (ETF) based on a limited universe of convertibles issued in the US, a global ETF is currently not in existence. Therefore, access to the global product can only be achieved via fund investment. Overall, the universe offers a diverse selection of investment profiles, which we believe should allow a fund to benefit from differing themes over the medium term. Conclusion: convertible bonds offer a potential solution The strong rally in global equity markets has helped alleviate the asset/liability mismatch that pension funds suffered as a result of the financial crisis. However, many still remain underfunded with asset allocation heavily skewed towards equities. With future liabilities continuing to rise due to increasing longevity, pension funds face a tough choice. Do they invest in equities with their exposure to rebounding global growth, but also higher volatility and potential downside risk? Or do investors settle for fixed income with much greater security of returns, but with their funds locked into yields at historically low levels? There is a third option convertible bonds. The embedded equity component would retain a degree of exposure to rising equity values, should economic expansion continue. When combined with the protection afforded by the corporate guarantee, this creates an investment with a much lower level of volatility and considerable downside protection. Given the current investment outlook, convertible bonds could offer an opportunity for pension funds to de-risk their overall portfolios, whilst maintaining considerable potential upside. Page 6
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