Super funds warm to fixed income but mass re-weight must wait

Investors with allocations to fixed income experienced gains as rates fell but the journey was always destined to run out of road. Liquidity injections off the back of the pandemic made conditions more strained as the pricing of credit risk and duration reached an all-time low. Fixed income assets – particularly sovereign and semi-government bonds – returned close to, or even less than, zero.

The custodians of Australia’s vast retirement pool, worth A$3.4 trillion (US$2.4 trillion) by March 2022, had a problem. The anchor of a traditional defensive strategy – fixed-income assets – had been engulfed by the wall of liquidity. Sovereign and semi-government bonds are typically used to buffer volatility in the equity market and investors around the world value exposure to top-rated paper linked to a robust currency.

But at low or negative returns, bonds were always prone to risk as and when rates turned upward. Perhaps more importantly, even in a low inflation environment most fixed income simply was not returning sufficient cash to fulfill its other primary objective of providing a liveable retirement income to superannuants.

Michael Clavin, Sydney-based head of income and markets at Aware Super, says these conditions were unprecedented during Australian superannuation’s 30-year lifetime. The change in conditions in 2022 is equally remarkable.

“It is an industry that, for the first time in many years, is dealing with a global high inflationary environment. Many asset classes, including fixed income and credit, can be challenged in such an environment,” Clavin says. “This has not happened to this extent in 40 years.”

Super funds progressively eased their allocations to fixed income as the yield trough approached. For example, between 2019 and 2021 Cbus reduced its exposure to government bonds to 6 per cent from 11 per cent of its total portfolio. In June 2021, with the RBA cash rate at 0.1 per cent, Aware Super removed government bonds altogether for members of its default fund aged 18-55.

HESTA, which uses sovereign bonds to express its view on duration, remains underweight in the asset class. “Rates have been so stimulatory, we need to wait until central banks restore them to more normal monetary policy settings,” says Jeff Brunton, head of portfolio management at HESTA in Sydney.

Having a defensive buffer in the portfolio mix has never stopped being a fundamental requirement for managers of retirement saving schemes that are mostly invested in growth asset classes. But low returns have shifted the emphasis to income assets that will pay at least some real return. In practice, this has meant increased exposure to credit – particularly for members in growth phase. At the same time, ultra-low yield in rates product has led super funds to favour cash.

For example, Aware Super’s product for members aged 18-55 has a 12 per cent defensive allocation made up of credit, cash, and some property and infrastructure – but no traditional fixed income. Even as Cbus reduced its exposure to government bonds it held onto its global credit allocation – a higher-yielding mix of corporate bonds, loans and structured securities.

Funds with strategies that rely on fixed income to meet future liabilities are running a finer calculus when calibrating allocation levels. When deciding which government bonds to include in its defensive bucket, Australian Retirement Trust – the result of a merger between Sunsuper and QSuper – targets lines that are likely to generate the highest yields. “These sovereign bonds offer the highest potential defensive benefits,” explains Andrew Fisher, head of investment strategy, super savings at Australian Retirement Trust in Sydney.

As rates have started to climb once more, fund managers say they believe traditional debt instruments will become more relevant again. There are some signs of assets coming back into the mainstream debt market: Cbus, for instance, has largely reversed its reduced allocation to the sector in 2022. But there is as yet no sign of a fully-fledged return to the mainstream bond market, as super funds argue there is plenty more readjustment to come.

Markets continue to price in interest rate hikes in response to increasingly stubborn inflation. At its last print, in March, the Australian Bureau of Statistics measured Australia’s consumer price index at 5.1 per cent, but some economists believe it could reach approximately 7 per cent by year’s end. Central bank policy moves are yet to quell inflation globally, either: US inflation passed 9 per cent in June despite successive Federal Reserve rate hikes.

In the minutes of its June meeting, the RBA noted mounting inflationary pressure and said its board expects to take further steps towards normalising monetary conditions over the coming months. Increases of 50 basis points in June and July were the largest since February 2000.

Gareth Apsey, Melbourne-based senior portfolio manager, rates and credit at Cbus, says any material increase to the fund’s fixed income allocation will not be appropriate until rates have peaked. “It is about looking for the best risk-adjusted return. This means we need to get into a position where rates are high but not still rising,” he says.

Until that point, the outlook for fixed income remains challenging. Clavin explains: “In a traditional pension fund, fixed income would offer stability and noncorrelated returns to equity markets during downturns. This was a huge plus side for someone in retirement,” he says. “When rates went to unpreceded lows, this convexity was not as apparent. Now, with unravelling government stimulus and rising inflation, the role of fixed income has been challenged further.”

Faced with falling sovereign-sector returns, the incomeseeking part of the debt allocation naturally sought yield elsewhere. This sparked an uptick in the appeal of credit assets, which are typically less liquid than rates but continued to offer at least some level of real return. This meant traditional investment-grade credit – but alternative investments, including private debt, arguably emerged to an even greater extent.

Clavin describes the initial uptake of private debt into pension fund portfolios as an opportunistic development. After the financial crisis, increased regulation of bank balance sheets created an opening for real-money funds to lend directly to companies, he says.

Now the groundwork has been done, Clavin says private debt is an allocation that is unlikely to go away even once traditional fixed income finds its way back into vogue. “There will be reallocation from alternative assets back to fixed income but some of the move into different areas of credit will be permanent,” he tells KangaNews.

This would be consistent with global trends. The Thinking Ahead Institute’s Global Pension Assets Study 2021 identifies the move away from fixed income investments toward alternative assets as one of five major themes that played out in 2021. “Alternative assets fill a fixed income-shaped hole in the asset mix via a shift that holistically pivots the total portfolio strategy,” the report notes.

Besides filling an income-producing void in portfolios, alternative investments hold other advantages that may see them become a mainstay. For Brunton, the asset-class’s flexibility for customisation is a key draw.

“Private debt gives us access to obligors that are different to what we can find in the public bond market,” he says. “They also give us the chance to negotiate better covenants or controls to ensure an obligor’s credit quality stays reasonably high for the life of the exposure.”

Brunton says alternative debt will be a permanent allocation for HESTA but he also emphasises that the allocation to private debt within the defensive bucket will always be modest. In some cases, the higher-yielding side of credit will count as a mixed allocation with shared benefits between defensive and growth portfolios.

“Fixed income is primarily there for defence and portfolio resilience, but it is also there for income,” Brunton notes. “This income can be thought about in terms of the type of credit risk we are willing to take. Investment-grade credit risk tends to keep the defensive characteristics of the allocation, whereas high-yielding alternatives within fixed income are thought of as a hybrid between defence and growth.”

Apsey has a similar view. He says Cbus is more likely to count high-yielding alternatives as part of its alternative growth pool. “Private debt falls into global credit or alternative growth,” he says. “It depends on the expected returns. Generally speaking, private debt falls closer to the alternative growth side due to its illiquidity risk.”

The other major shift in market paradigm asset allocators have had to deal with is the breakdown in negative correlation between debt performance and that of traditional growth assets. This correlation was an advantageous relationship that saw bonds insulate equity downturns.

When debt and equity markets respond to a common influence, in this case a sharp rise in inflation, prices are inclined to move in tandem – or be positively correlated. This story has played out many times of late – starting with the financial crisis, when common themes of illiquidity and financing risk saw debt and equity markets fall in unison.

A well-timed increase in allocations to fixed income would likely coincide with a restoration of the negative correlation. Super funds say a return to a negative correlation between bonds and equities would be welcome, but they again expect this to be some distance away.

The seesaw relationship between the debt and equity markets that underpins the traditional risk model could also re-establish itself once the tightening cycle has played out.

Then again, Apsey warns there is no guarantee the reality will match what makes sense on paper. “The catch-all disclaimer is that correlations change over time and they rarely work when we want them to,” he comments. “Nothing is constant, and even if we can say the negative correlation will hold it depends on where equity and bond markets are as well as valuations in asset classes like property and infrastructure. A lot of moving parts that make up a portfolio.”