Institutional investors seek returns in high yield, inflation protection

In a tough 2021 for fixed income amid rising inflation, many pension plans saw their exposures to high-yield bonds and inflation-protected securities increase as these were among the few fixed-income assets classes to perform relatively well.

Now, facing the specter of imminent interest rate hikes by the Federal Reserve, pension funds are bracing for more dismal returns within the fixed-income segments of their portfolios.

John Delaney, Philadelphia-based senior director and portfolio manager at Willis Towers Watson PLC, said pension funds should focus on positioning portfolios to potentially be successful regardless of the interest rate environment. “This can be achieved by managing portfolios with high carry or yield, as that can provide a cushion against rising rates or an increase in defaults,” he said. “Investors may choose to go down in quality to increase the yield on their portfolios, but we believe that investors are better off accessing less crowded markets ... This could be certain pockets of the private debt universe, or emerging market debt space, where higher-yielding high-quality issues are still available for investing.”

High-yield bonds and Treasury inflation-protected securities outperformed the broader fixed-income market for the year ended Sept. 30: the Bloomberg U.S. Treasury Inflation Notes index gained 5.2% and the Bloomberg U.S. Corporate High Yield index jumped 11.3%, while the Bloomberg U.S. Aggregate Bond index slipped 0.9%.

This data was reflected in portfolio holdings of some U.S. pension funds.

In the year ended Sept. 30, high-yield assets for defined benefit plans among the 200 largest plan sponsors rose by 21% to $98.4 billion, according to Pensions & Investments data, while inflation-protected securities assets grew by 11.5% to $62.8 billion over that period. Overall, active domestic fixed-income assets among the plans jumped by 10.6% to $943 billion while passive domestic bonds increased by 49.3% to $220.6 billion.

Mr. Delaney was not surprised that some pension plans across the country increased their allocations to high-yield bonds and inflation-protected securities last year.
Indeed, in a climate of tepid to poor performance by most fixed-income classes in 2021, high-yield bonds as well as bank loans were among the strongest performers.

“Some (pension fund) managers were willing to raise their risk in order to get some yield from high-yield bonds as yields for Treasuries and investment-grade corporate bonds were quite low last year,” he said.

Mr. Delaney said many of his pension fund clients have expressed worries over higher inflation and the likelihood of two or three rate hikes by the Fed this year — as well as their potential impact on all major asset classes.

In such a scenario, Mr. Delaney thinks some managers may continue to invest in high-yield bonds, bank loans and other higher carry alternative credit exposures this year, as these securities are less sensitive to higher interest rates than investment-grade bonds.

As for inflation-protected securities, including TIPS — whose principal increases with inflation and falls with deflation — Mr. Delaney thinks pension funds may use them as a “risk management exercise,” not as a way to generate higher returns.

Some funds, he noted, may also seek to buy into private debt and less-liquid fixed-income securities for higher carry, lower duration and less correlation with other more liquid asset classes.

Some large pension plans underwent significant changes in their exposures to actively and passively managed bonds last year.

For example, the $70.4 billion Pennsylvania Public School Employees’ Retirement System, Harrisburg, saw its exposure to passive domestic fixed income jump by 54.7% over the year, while exposure to active domestic fixed income fell by 39.1% over that period.

Steve Esack, a spokesman for PennPSERS, said by email that the pension fund’s target to active non-U.S. inflation-protected fixed income was reduced to 3% of the total fund in 2021 from 9.5% in 2020, while U.S. TIPS increased to 12% from 9.5% with the increase going to passive management. About 86% of the internally managed U.S. TIPS portfolio was passive as of Sept. 30, up from a 56% passive/44% active split a year earlier, Mr. Esack said.

The pension fund also reduced its target to active U.S. core bonds to 1% from 4% and increased active U.S. high yield to 2% from zero.

Laura Wirick, a managing principal and investment consultant at Meketa Investment Group, said the move by some pension funds to increase their exposure to high-yield bonds and inflation-protected securities was likely due to a combination of both market movements and proactive decisions by boards, internal staffs and external asset managers to shift allocations.

Ms. Wirick, who is based in Carlsbad, Calif., said that while pension funds are concerned this year about inflation and potentially higher interest rates — which could make high-yield bonds, bank loans and private debt attractive within the fixed-income universe relative to most investment-grade corporate and government bonds — she does not expect pension funds to make significant shifts in asset allocations.

She also noted that while the Fed will likely hike rates this year, rates still remain at historic lows — meaning there is probably not a lot of urgency in significantly changing investment targets.

“Five years ago, U.S. pensions funds had about 27% of their assets in fixed income and now that figure is at about 25%, so these overall allocations have remained very stable through recent economic conditions,” she said of large public plans.

Public pension funds in P&I’s top 200 had an average domestic fixed-income allocation of 20.2% and another 1.6% to global/non-U.S. bonds as of Sept. 30, down from 21% and 2.3% the year before, respectively.

However, Ms. Wirick added that some pension plans might be willing to add some risk to their fixed-income portfolios in order to capture higher yields in what is likely to remain a low-yield environment.

Michael Haddad, interim chief investment officer of the Bureau of Asset Management, which serves as investment adviser to the five New York City Retirement Systems pension funds, said market appreciation and rebalancing — rather than changes in asset allocation — led to the large increases these funds saw in their exposures to domestic fixed income assets (up 20.6%), inflation-protected securities (up 10.8%) and high-yield bonds (up 30.3%) in the year ended Sept. 30,.

The New York City Retirement System accounted for an aggregate $266.7 billion in assets as of Sept. 30.

He noted that all five funds completed a strategic asset allocation prior to June 30. “As equity markets performed well last year, we became overweight there, so to reduce risk we rebalanced and moved some assets to these fixed-income sectors,” he said.

Expecting a “dismal” outlook for most bond products this year, Mr. Haddad expects his portfolio will maintain current allocations to TIPS, given their relative outperformance during periods of rising inflation.

“Although we are long-term investors and seek to deliver good returns through various economic ups and downs, we and our trustees are concerned about higher inflation and rising rates,” he said.

New York City Retirement System also saw a nearly 100% plunge in bank loan assets from $2.7 billion as of Sept. 30, 2020. Mr. Haddad explained by email that trustees from the five pension plans voted to eliminate bank loans from their portfolios in the first half of 2021, and that the decision was “purely to create additional space in the basket clause allocation” as bank loans are counted as a “basket asset” by New York state law.

Mr. Haddad noted that the fixed-income portfolio of three of the five pension funds he oversees has reduced average duration to 6.5 years from about 8.5 years in order to reduce the risk of these portfolios losing value amid rising rates. The other two pension funds’ fixed-income portfolios already had average durations around 6.5 years.

James Bennett, chief investment officer of the Maine Public Employees Retirement System, Augusta, said changes in his fund’s asset mix were due entirely to efforts at maintaining its target allocations.

For the year ended Sept. 30, the $18.6 billion fund’s exposure to fixed income jumped by about 36.5% to $2.9 billion — however, that was due largely to rebalancing, he noted. “As our equities (both public and private) grew in value during the year, we rebalanced into fixed income to maintain our strategic weights,” he said.

MainePERS has a policy weight of 15% for fixed income, Mr. Bennett said, all passively managed. “We rebalance as needed to stay close to our target weights. This has required more trading than usual since COVID struck. We reduced fixed income in March 2020 in order to rebalance into equities, and since then (we) have regularly sold down equities to rebalance into fixed income as equities appreciated dramatically.”

The fund’s inflation-protected securities portion of the fixed-income portfolio grew by about 10.1% to $1.25 billion during the year ended Sept. 30. He said the investment team does not make any tactical decisions based on such factors as inflation or interest rates.

Mr. Bennett noted that prior to 2017, the fund had a higher allocation to fixed income — 25%, split equally between credit and U.S. government debt; much of that was reallocated into alternative assets.

In calendar 2021, MainePERS had a total return of 19.5%, net of fees, vs. a 16.3% return for its benchmark. Its fixed-income portfolio gained 1.9%.

Mr. Bennett added that the fund is currently reviewing its strategic asset allocation and expects to complete this process by June 2022.

The $46.3 billion Indiana Public Retirement System, Indianapolis, saw a huge 165.1% surge in its exposure to inflation-protected assets for the year ended Sept. 30 to $6.2 billion.

But a spokesman for INPRS said this increase was partly due to changes in asset allocation targets. Following an asset-liability study, the system in May increased the target allocation to inflation-linked assets to 15% from 13%, he said.

INPRS’ allocations to domestic and global fixed income increased by 29.4% and 40.2%, respectively, for the year. The spokesman said by email that INPRS “re-classified manager accounts from the commodities mandate to the inflation-linked bond mandate, which impacted (its data). ... That is the primary driver to the increases in domestic and global fixed income data.”

INPRS declined to comment further.