U.S. funds turn to fixed income for relief

U.S. pension fund executives expect to navigate a recession by the end of 2023, but while the market return environment is set to remain challenging, they see opportunities re-emerging in fixed income.

While they are unsure of just how challenging, they are convinced of one thing: a recession almost certainly looms in the coming year.

"My crystal ball is a bit cloudy," said Christopher J. Ailman, chief investment officer at the $307.2 billion California State Teachers' Retirement System, West Sacramento, in a phone interview. "I'm always reminded of the works of Howard Marks. It is virtually impossible to make predictions, especially ones about the future. We should have a recession in '23. The question is: Is it severe? It is mild? As one of my peers said, if we do in fact have a recession, it is the most anticipated recession in four years. Everyone is expecting it, which means they can all be wrong."

The level of expectation is due to a rising interest rate environment that defines the coming year after well over a decade of near-zero rates, as the Federal Reserve took aggressive steps to turn the tide of inflation in this past year — steps that reached the Fed's latest action on Dec. 14 when the Federal Open Market Committee raised the federal funds rate to a range of 4.25% to 4.5% following its two-day meeting.

Paul M. Colonna, president and chief investment officer of Lockheed Martin Investment Management Co., said in a phone interview that the interest rate hikes have created the biggest inflection point he has seen in the marketplace in a long time. In his role, he oversees more than $30 billion in frozen defined benefit plan assets of Lockheed Martin Corp., Bethesda, Md.

"It opens up a lot of new avenues for investments that quite frankly were not that attractive for the past decade or so," Mr. Colonna said. "It's given us opportunities where ... you're talking about 5% or 6% yields on high-quality fixed-income assets, and that differential on our long-term assumptions on equity returns ... is as narrow as it's been in a very long time."

Mr. Colonna said it provides a great opportunity for Lockheed's pension fund portfolio not only to manage the risk but provide a return-generating income.

Corporate defined benefit plan sponsors have asked in recent years: "Do you hedge or do you seek returns?"

"Now we have the chance to potentially do both," Mr. Colonna said.

As a result, he said the portfolio is going to go more into long-duration fixed income. "That's a place we've obviously been active, but we're going to be more active. We're going to be allocating more dollars to high-quality investment-grade (fixed income)."

Charles Van Vleet, assistant treasurer and CIO of pension investments at Textron Inc., Providence, R.I., said he is focused on how the markets will play out in 2023, and as a result he and his staff will be going to the firm's investment committee to widen target allocation ranges to provide further flexibility in a volatile market environment.

"I want to be able to allow allocations to drift — not be forced into selling or buying because of range limits," Mr. Van Vleet said in a written response to questions. He oversees over $13 billion in defined benefit and defined contribution plan assets for the company.

Other plan executives are positioning their allocations in anticipation of market dislocation.

Farouki Majeed, CIO of the $16.5 billion Ohio School Employees Retirement System, Columbus, said in a phone interview that his investment portfolio benefited from being underweight to equities and fixed income during the most recent fiscal year.

The pension fund returned a net -0.5% for the year ended June 30 during a period in which the Russell 3000 index and Bloomberg U.S. Aggregate Bond index returned -13.9% and -10.3%, respectively.

As of Nov. 30, the pension fund's actual allocations to global equities and global fixed income were 40% and 12.2%, respectively — well below their respective targets of 45% and 19%.

Mr. Majeed said the question is what fixed income will bring in 2023. "We expect interest rates to peak sometime toward the end of this year or the first quarter of 2023 so we've been cautiously adding to fixed income so we're trying to kind of close the underweight that we have somewhat," Mr. Majeed said.

Inflation seems to be cooling, as evidenced by the Bureau of Labor Statistics' Dec. 13 report that the consumer price index rose 7.1% from a year ago in November, falling below economists' expectations of a 7.3% increase.

However, Mr. Majeed said that while the CPI reflects items like falling gas prices, other factors like rent prices "seem to be much more sticky, so we think while inflation may trend down, it's probably going to remain elevated a little longer than people are expecting, so that is a concern for us."

As a result, Mr. Majeed said SERS will likely remain considerably underweight to global equities.

Other executives also see opportunities within fixed income.

"Inflation has increased but so have the returns around equities, and more importantly fixed income," said Angela Miller-May, CIO of the $47.3 billion Illinois Municipal Retirement Fund, Oak Brook, in a phone interview. "And because of that we don't have to continue to take the type of risks that we've taken over the last five to 10 years to kind of meet our actuarial returns. We can kind of lean into fixed-income products, whether it be bank loans or high yield."

With interest rates rising and 10-year Treasury yields falling, Ms. Miller-May said, the diversification benefits are improving between equity and fixed income after the previous year saw negative returns from both asset classes, and the pension fund also plans to look for opportunities in core fixed income.

Meanwhile, investment staff at the $48 billion Arizona State Retirement System, Phoenix, will be focused on private credit markets.

Paul Matson, executive director of the pension fund, said in a written response to questions that staff will be focusing primarily on private credit markets after marginally increasing the plan's target to the asset class to 23% of the total fund from 20% following an asset-liability study.

"Given our unique separate account structure with private credit and private real estate, we believe that our fund-level liquidity is relatively high," Mr. Matson said. "We also believe that although project and corporate level access to capital may be more stressed in 2023, this may lead to greater private credit returns, while resulting in only muted private real estate returns. Given the typical lag between public and private equity valuations, we see private equity returns as being more modest than potential public equity returns."

Over at CalSTRS, meanwhile, Mr. Ailman said investment staff has been concentrating on raising liquidity and finding diversifying assets.

"I think 2023 is going to be a year in which everyone is focused on coupon income, dividends, trying to get cash flow on their investments, and it may be a year in which the key is preserving capital," Mr. Ailman said.

Andrew H. Junkin, who joined the $98.9 billion Virginia Retirement System, Richmond, in September to replace retiring CIO Ronald D. Schmitz, said in a phone interview that he and his staff are in the middle ground when it comes to the severity of an upcoming recession.

In his first months with VRS, he has spoken with a number of the system's external managers, who have taken polls of their portfolio company executives.

"Seventy-five percent of company managers don't think there's going to be a recession or it wouldn't affect their companies," Mr. Junkin said. "Maybe there's a little bit of salespersonship going on there, but it's not in line with what we're beginning to see."

One asset owner executive has another concern. Mr. Van Vleet fears the next big shock will occur in Japan.

"When real rates go from -1.5% to +1.5%, stuff breaks," he said. "I fear the next breakage will start in Japan. They are under pressure to end their decadelong yield curve control. It is not going to be pretty. Ten years of nearly zero rates with no volatility suggests there is massive leverage in the system — both private and public. Rising JGB rates, and yen strength is a pain trade that can have spillover impact on financial assets around the world."

"I was raised in California," Mr. Van Vleet said. "Every year in California, there are hundreds of earthquakes, a half-dozen which you can feel. All native Californians know that lots of small earthquakes is a good thing. It means there is less stored-up kinetic energy for a 'big one.' Japan has not had any financial-asset or rates earthquake in a decade. Lots of stored-up energy for a big one."