Interest rates have been declining for nearly 40 years. There are many factors driving the current low interest rate environment: central banks trying to stimulate their economies and or stave off recession; muted inflation; weak global growth; protectionism; ongoing geopolitical uncertainty; aging populations; and the demand for traditional fixed income outstripping supply.
It is more difficult to meet average pension fund internal return targets without taking on more known and unknown risk. For example, in 1995 a 7.5% expected return came with 6% of standard deviation (a measure of risk). In 2015, generating the same return required taking almost three times the amount of risk (17%), according to investment consultant Callan Associates.
Figure 2. Expected Returns vs. Risks
Source: Callan Associates, Bond Capital
Yet, current factors exist to drive interest rates even lower. According to Rick Rieder, global chief investment officer of fixed income at BlackRock, although a US recession over the next couple of years is possible, the Fed could respond by cutting interest rates to zero, reigniting quantitative easing. At the same time, banks are being disintermediated by the growth in private credit, which has also shrunk the supply of new corporate debt, leading to a dearth of higher quality investment-grade issuance. Net supply from municipal borrowers, another vital source of new issuance, has also turned negative so that there is not enough available for pension funds and insurers to buy. Moreover, some of those same current factors have led to an increasing issuance distribution shift of “investment grade” bonds toward lower ratings. Not only are pension funds likely to enjoy less yield they must do so with additional risk. While the corporate bond market has increased from around $4 trillion to $5.8 trillion this growth has been accompanied by a steady decrease in overall credit quality. The share of the U.S. investment grade nonfinancial bond market rated BBB (i.e., the lowest credit rating still considered investment grade) has increased to 48% in 2017 from around 25% in the 1990s according to PIMCO. Moreover, according to Morgan Stanley Research U.S. investment grade credit issuers are increasingly leveraged with junk bonds (those rated BB or lower) making up over 50% of all rated bonds. Look before you leap!
Certain pension funds and insurers will experience interest rate risk first hand as old higher-yielding matured bonds are replaced by new lower-yielding bonds in their portfolios. Lower interest rates will lead to lower returns for pension funds and insurers, some of which invest around 40% or more of their assets in fixed income securities. With interest rates expected to remain low, pension funds and insurers may find their assets insufficient to meet their obligations unless they adjust their pension allocation or payment promises.
In response certain pension funds are implementing a fixed income overlay strategy. This includes the use of derivatives, in some cases the use of leverage and for the majority an increased allocation into the private credit asset class. A private credit investment strategy is well suited for “all weather” returns as part of a modern fixed income composite. Asset allocators should know that private credit benefits from primary security, collateral security and a floating interest rate payment obligation amongst other things.
A strategic allocation to modern fixed income means getting paid for the risk you are underwriting. Traditional fixed income in its modern form needs to be enhanced through the use of both liquid (derivatives) and illiquid (private credit) income overlay strategies to make up for lower issuance, increasing leverage and declining average credit fundamentals in the public bond markets.