Fixed income's triumphant return

It's been a long time since fixed income was in vogue, but bonds are back. Over the last 10 months, both the Fed Funds rate and the Bank of Canada’s overnight rate have climbed from 0.25% to 4.5%, with the 10-year U.S. Treasury yield now standing at about 3.5% – a return investors can finally get excited about. Yields could continue increasing if the Fed keeps hiking rates, as many expect them to, while a return-boosting rate cut could come at some point as well, after inflation is contained.

Bonds have provided some value for pension funds since 2008, but lower yields and the diminishing prospect of positive gains as interest rates bottomed forced mangers to rely on equities to increase returns. While funds continued to hold fixed income – often for interest rate hedging – many pared back their asset allocations, resulting in companies taking on more market risk than they'd like to meet their obligations. Now, with bonds offering income and the prospect of decent returns at lower risk than stocks, pension funds may want to consider allocating more to this asset class again.

An attractive asset class

There are some good reasons for funds to rethink their asset mix. For instance, as yields have increased, so too have interest rate spreads, meaning that yields for lower-rated, emerging-market and even investment-grade corporate bonds are now much higher than the 10-year Treasury bills. Not only can funds earn decent incomes from these securities, but those spreads could compress at some point – potentially when the economic outlook improves. When they do, funds holding higher-yielding bonds will realize market value (as long as the issuer doesn't default) from those holdings.

Bonds are also more compelling in an absolute sense. With the likelihood of a global economic downturn, many are predicting lower returns for stocks in 2023, which means bonds could do what they've historically been meant to do: offer returns when equities decline.

The rise in interest rates has also made borrowing more expensive, resulting in private equity, real estate and other leveraged investments becoming less attractive. Funds that were early buyers of private assets may now find themselves overweight in the asset class and could be looking to offload their holdings, putting further pressure on private equity valuations. That's a favorable scenario for bonds.

Look at liabilities, too

The better bond environment doesn't just impact the asset side of the balance sheet – it also affects liabilities. When bond yields (and spreads) increase, the discount rate for U.S. corporate pension plans as well as many Canadian and European plans can rise, too. Over the last decade, with interest rates and discount rates both low, liabilities were generally high, resulting in many funds being underfunded or close to underfunded. This caused some plans to invest more aggressively in equities to improve their funded ratio outlook. With increasing discount rates liabilities shrink, improving the funded position of many plans. Higher funding ratios can have a profound impact on a fund’s optimal mix, allowing managers to de-risk their portfolios. This also allows plans to increase their allocation to fixed income in order to increase the liability hedge, protecting the fund from potential future interest drops.

We expect fixed income to remain attractive for some time. Interest rates should moderate to current – or somewhat below current – levels after peaking early in 2023. We don’t expect them to return to the low levels of the past few years.

How much a pension must allocate to fixed income depends on many things, including funded position, risk-appetite, long-term goals, inflation-compensation and regulations. More managers, however, will boost their allocations. All companies want to improve the funding ratio outlook, keep their plans affordable, reduce the probability or reliance on additional contributions and improve (conditional) benefits. If that possibility improves by allocating more to fixed income, then managers must make that switch. It's taken some time, but we've entered a new environment that offers more asset allocation balance. Now may be the time for pension fund managers to make their move.

Bonds have provided some value for pension funds since 2008, but lower yields and the diminishing prospect of positive gains as interest rates bottomed forced mangers to rely on equities to increase returns. While funds continued to hold fixed income – often for interest rate hedging – many pared back their asset allocations, resulting in companies taking on more market risk than they'd like to meet their obligations. Now, with bonds offering income and the prospect of decent returns at lower risk than stocks, pension funds may want to consider allocating more to this asset class again.