Months before corporate bond funds began to attract net inflows, United Utilities’ £1.5bn pension plan was making a substantial commitment to the sector. By the time the move into AA UK corporate bonds was implemented between July and September 2008, the default of Lehman Brothers was still in the near future. When October arrived, a joint group of trustees and company officials stayed the course. “Our decision was a deliberate policy rooted in the belief that at the time the extra value on corporate yields more than compensated the risk we took in excess of gilts,” says Steven Robson, Pensions Manager at United Utilities.

Today, United Utilities is sitting on a sizeable corporate bond mandate run by Legal & General. It accounts for 39% of the portfolio, up from 10% before the move, while its equity allocation dropped from 70% to 52% and its indexed-linked gilt allocation went from 10% to zero. The fund is 5% invested in fixed-interest rate gilts and 3% in cash.

Corporate bond funds, from high yield to investment grade, have posted some of the best results year-to-date. By March this year, high grade bond funds were seeing inflows averaging $2.3bn per week, with total inflows of $32.8bn, according to JP Morgan Chase. High yield funds have also fared well: Fidelity’s Capital & Income Fund, a US-domiciled open fund with an emphasis on lower quality debt securities, is up more 21% year-to-date (into May 14). Yet performance was not the main driver behind the pension fund’s investment in high-grade bonds, says Robson. “We have been looking for ways in the past two years to de-risk the fund without significant impact upon performance and this option helped us to match our assets and liabilities on a duration basis.” The joint group initially considered gilts but was drawn to investment-grade corporates as spreads widened.

Pimco

Other institutional investors are also seeing opportunity in high-grade bonds. Pimco, with £127bn in assets managed from Europe, has been a strong advocate. “We expect high quality corporate bonds to outperform gilts given the high excess yield available,” says Mike Amey, Executive Vice President and Sterling Portfolio Manager at Pimco London. “We would, however, caution that given the level of economic uncertainty our preference is to stick to the strongest non-government issuers. Given that corporate bond yields have already risen sharply, we believe the best way to protect pension fund solvency is to favour high-quality corporate bonds over gilts.”

United Utilities’ investments in corporate bonds are in the high-grade category. The joint group expects that the strategy will start the process of mending the pension fund’s funding ratio. As part of its new strategic guidelines, the Pensions Regulator has hinted that it will accept longer recovery plans from under-funded UK pension schemes and Robson states that the pension fund has placed a 65% probability that the scheme will achieve near full funding in 10 years. The Regulator has said that it may allow schemes to go beyond the 10-years it prescribed in its previous strategic guidelines.

Another source of strategic advice is likely to come from a tender the pension scheme is overseeing for a fiduciary manager. The manager, will be appointed in June and will assist the joint trustee-company group on asset allocation and de-risking issues. The asset manager selection process will remain with the pension fund. At the moment, the fund has an agreement to invest up to 10% of the assets in alternatives and this will likely be funded from its equity allocation in the future. The scheme has a 3% position in GTAA, which is considered part of its equity allocation. Once the fiduciary manager is selected and a governance structure is put in place, the scheme will begin to diversify into other alternative assets and strategies, among those that will be considered are FOHFs and property.

VB