Institutional investors question fixed-income allocation

The poor outlook for fixed-income returns is pushing some institutional investors to consider more-active approaches to managing their fixed-income portfolios.

“The real challenge for a chief investment officer or an investment committee is meeting the plan’s expected rate of return. If 8% is your number, it’s going to be hard to generate that return in a zero-rate environment for the foreseeable future,” said David C. Saunders, managing partner of hedge-fund-of-funds firm K2 Advisors LLC.

For more than 30 years, interest rates drove core fixed-income returns “in a very delicious direction,” said John T. O’Shea, a managing director and institutional client adviser at J.P. Morgan Asset Management. He added, however, that in this climate, “mathematically, bonds will have to have a bad year, and with two-year Treasuries yielding only 17 basis points … there’s not much left before you get into negative returns.”

One consequence of efforts to goose fixed-income returns likely will be the dismantling of the venerable core-plus bond approach, at least in its traditional form, according to investment consultants.

“The reality is that with such expected low fixed-income returns, given 10-year Treasury yields, many of our clients are questioning their fixed-income allocation,” said Eileen Neill, managing director with investment consultant Wilshire Associates Inc.

A growing number of pension funds have separated or are considering separating core fixed-income and alpha-oriented credit strategies (the “plus” in core-plus) into disparate allocations.

“In the current [interest] rate environment, an investor’s ability to eke out returns is going to be very difficult using a core or core-plus approach,” said Steven Center, a vice president of global manager research at Callan Associates Inc.

LOOSENED CONSTRAINTS

Some institutions are maintaining their core-plus allocations but have loosened the constraints on their bond managers to allow them to invest in a broader part of the credit spectrum or in investment opportunities globally.

Whether pension fund officials are deconstructing core-plus bond portfolios, giving managers more latitude or reducing the allocation to core-plus managers to add specialist credit managers, “investors are more heterogeneous than they ever were,” Mr. O’Shea said.

The $6.9 billion Municipal Employees’ Retirement System of Michigan separated its traditional fixed-income portfolio from more alpha-oriented strategies. The fund’s $1.6 billion traditional core-fixed-income portfolio already has been tweaked to give managers latitude to find more sources of return.

“We’ve been moving in the direction of a more active allocation strategy in our fixed-income portfolio. We’ve given some of our core bond managers more flexibility to cover a broader spectrum to include global bonds,” said Jeb Burns, chief investment officer of the Michigan municipal retirement plan.

“It’s the same wheelhouse, but the fishing pond is a little bit bigger,” he said.

As part of that move to a more explicit, active management approach, the staff plans to shift Michigan’s $483 million (7%) high-yield bond allocation into an opportunistic fixed-income portfolio, Mr. Burns said.

The move will allow the fund to invest in a broader range of credit opportunities, such as distressed debt, bank loans and leveraged loans.

Mr. Burns said that a search for opportunistic credit managers likely will be launched in the second quarter of next year.

For many public funds, the core-fixed-income portfolio likely will continue in its traditional role as a conservatively managed allocation that mitigates the volatility of equity exposure, Mr. Center said.

For corporate plan sponsors using a liability-driven strategy, the primary investment approach will remain long-duration bonds.

“It’s important to remember that the fixed-income portfolio is the anchor … which acts as a volatility dampener. It is not a place where you should seek return,” Mr. Center said.

Chief investment officers are carving out dedicated allocations to higher-risk, higher-return, less liquid and more esoteric credit-related investments than most core-plus bond mandates would have permitted, observers said.

Some of those subasset classes are distressed debt, long/short fixed-income hedge funds, emerging-markets debt, high yield and bank loans, consultants said.

‘PLUS’ BUCKET

It is the newly separated “plus” bucket, often labeled credit opportunities, where the new diversity of fixed-income portfolio changes can best be seen.

The $75 billion Ohio Public Employees Retirement System is taking steps to restructure and diversify its fixed-income portfolio.

The fixed-income allocation remains at 25%, but the core bond target was dropped to 13%, from 18%, fund spokes- man Michael Pramik wrote in an e-mail.

The fund used the reduction to fund target allocations of 2% to emerging-markets debt and 1% each to global high-yield, floating-rate debt and high-yield securitized debt.

The system will hire new managers or use existing managers for emerging-markets debt, global high-yield and floating-rate debt. The high-yield securitized portfolio will be managed internally.

The changes are expected to take effect by Jan. 1. According to a notice on the system’s website, searches are being conducted for two to three emerging-markets-debt managers and two global high-yield managers. Each manager will run between $300 million and $400 million.

The $21.7 billion Iowa Public Employees’ Retirement System also is restructuring its U.S. high-yield portfolio into a credit opportunities allocation, based on a recommendation from staff members and Wilshire Associates, the fund’s consultant.

The allocation to credit opportunities will be 5% of total fund assets, the same as the former high-yield allocation, and will include sovereign and corporate emerging-markets debt, Iowa chief investment officer Karl Koch wrote in an e-mail.

As part of the shift in strategy, the Iowa system’s staff expects approval to search for emerging-markets debt managers to run a total of $350 million, he wrote.

This year, the Iowa Public Employees’ Retirement System is restructuring and diversifying as much as $4.1 billion in core-plus assets, Mr. Koch wrote.

Barry Burr, Timothy Inklebarger and Rob Kozlowski contributed to this story.

Christine Williamson is a reporter for sister publication Pensions & Investments.