Asset allocation to corporate bonds may have peaked
LONDON, January 22, 2008 – Despite early confidence and positive returns in the first half of 2007, by the end of the year, UK pension funds had seen a reversal in fortunes. This was triggered by the global ripple effect of the credit crunch, says BNY Mellon Asset Servicing.
2007 proved to be a challenging environment for most investors, with both inflation and interest rates rising in the early months. The RPI peaked at 4.8% in March and UK base rates rose to their highest level of 5.75% in July. Equity returns were generally positive in the first six months and generally negative in the second half of the year. This pattern was reversed in fixed income.
UK Equities returned 7.3% and -2.1% in the two halves respectively. European Equities followed a similar pattern, with 11.1% in the first half. Returns in the second six months would have been negative, but sterling’s weakness relative to the Euro, boosted returns to 3.8%.
UK fixed income securities produced negative returns in the first half, -3.1% on gilts and -2.4% on corporate bonds. They both bounced back in the second half, returning 8.6% and 4.3% respectively.
Property gave up its relentless rise over many years and returned -9.8% in the last six months. Hedge funds, overall, had a fairly successful year, with the majority of their positive returns earned in the first half of the year (7.6%), but still managing small positive results in the second half despite the market conditions.
Commenting on the performance of UK pension funds in the last 12 months, Alan Wilcock, Performance and Risk Analytics Manager at BNY Mellon Asset Servicing, said: “Despite a relatively strong start, the credit crisis that started with the sub-prime mortgage market in the US could no longer be ignored and spread to other structured securities and the bond markets generally. Equity markets started to feel the impact from the summer onwards. These key factors turned 2007 into a year of two halves.”
Markets become more volatile in 2007 (but 2002 was worse)
Analysis of performance shows that daily return volatility, intra month, on the UK equity market certainly picked up in the second half of 2007. However, it was still not the highest BNY Mellon Asset Servicing has recorded in the last 10 years and substantially less than in the summer of 2002. Over rolling one-year or three-year periods, using monthly returns, the impact of the changing markets was not that noticeable and levels remained well below those seen earlier in the decade.
In the bond markets, gilts and corporate bonds showed signs of higher daily volatility at the year end, but the longer term statistics were not unusual.
Has allocation to corporate bonds peaked?
Since the turn of the century the average allocation of UK pension funds to bonds has risen from 14.2% to 25.7% of assets (as of 30 Sept 2007). Of that the UK gilt element has risen from 9.1% to 11.2%, but remarkably UK corporate debt holdings have risen from 1.2% to 12.9% of assets. This has been at a time when corporate bonds have generally outperformed gilts, with the exception of the second half of 2007.
“The majority of UK pension funds have built up their corporate bond holdings during a period when they delivered excess returns over gilts, only to see that advantage wiped out in the second half of 2007,” said Wilcock.
Changing market conditions and the associated results are starting to have an impact on allocation of funds to the different investment sectors. Results from the pooled fund survey show that there have been modest net withdrawals from active gilt funds over the year. In addition, the tide of money flowing into active corporate bond funds looks to have turned in the final quarter, when cash flow was neutral overall.
Property funds showed a similar swing; the pivot point being in the summer, with in-flows in the first half of the year and out-flows in the second half.
Active Currency Management adds value in 2007
Pure currency management in first 11 months of 2007 managed to add value with a return on 1.05% in this period (as measured by the SEB Mellon Currency Index, which measures pure currency returns). This made up for the losses in 2006 when the index returned -1.15%. 2005 was also a good year when the average manager added 2.36%.
Nick Rogers, Performance & Risk Analytics Product Specialist at BNY Mellon Asset Servicing, commented: “Assessing the level of risk in these results, the overall statistics point to an information ratio of 0.4 in 2007 and the same over the three year period, which is usually considered to be an attractive ratio.”