Asset owners consider broader fixed income mandates amid rising sovereign debt yields
The yield on a 10-year gilt is at its highest level since 2007, so what does this mean for the investment decisions made by asset owners? (Yui Mok/PA Wire)
Against a backdrop of elevated bond yields in the UK and other developed markets, some European investors are reconsidering allocations to sovereign debt in favour of broader active fixed income strategies.
In the UK, Labour's new chancellor John Healey has sought to reassure markets of the party's commitment to fiscal discipline amid rising bond yields. This came as the yield on a 10-year gilt hit 5.29 per cent on September 2, trading at its highest level since 2007.
Matthew Amis, investment director for rates management at Aberdeen Investments, says: "With gilt yields at [higher] levels, the fiscal room for manoeuvre going into October's budget is incredibly limited."
Along with the UK, other developed market sovereign debt markets have also seen sell-offs following renewed tensions in Iran and rising oil and gas prices. As the price of oil hit more than $90 (£66) a barrel in early September, the yield on a 10-year US Treasury note hit 4.81 per cent, a level not seen since November 2023.
Ben Ritchie, head of developed markets equities at Aberdeen Investments, says the recent rise in bond yields "is something to monitor closely".
He adds that it is "important to distinguish between a gradual repricing of yields, which markets can absorb, and a disorderly loss of confidence".
Recent bond moves have "been driven primarily by higher real yields, fiscal concerns, rising government borrowing requirements and heavy private-sector funding needs linked to AI investment, rather than by a loss of confidence in central banks or a surge in long-term inflation expectations," Ritchie says.
Even so, Amis says that "until oil and gas start freely moving in the Strait of Hormuz, gilt yields are going to struggle".
Amin Rajan, chief executive of Create-Research, tells MandateWire Analysis that asset owners have reacted differently to the recent rise in yields depending on their investor profiles.
Higher yields have proved attractive to investors that typically use bonds for their predictable cash flows and ability to match liabilities, Rajan says.
However, he says investors seeking a higher total return are "not happy, because higher yields can be more than offset by capital losses, given the inverse relationship between yield and capital appreciation".
Indeed, amid increasing disquiet in bond markets this summer, some European investors have either retreated from sovereign debt allocations or shown a preference for other types of fixed income.
In August, we reported that the £11bn Merseyside Pension Fund had increased its focus on credit while moving away slightly from government bonds in its proposed strategic asset allocation, due to be approved at its next pensions committee meeting on September 22. Peter Wallach, pensions director at the fund, told MandateWire that the pension fund has been cautious when allocating to fixed income.
Within the fund's proposed fixed income allocation, credit will account for 10 per cent of assets, while UK government bonds will make up 7 per cent.
Wallach said the fund's fixed income portfolio had been altered in response to the government's strategic asset allocation template, set out in statutory guidance for Local Government Pension Scheme funds published in June. All schemes must follow the SAA template, which includes separate categories for UK government bonds and credit.
However, Wallach did not provide further details on why the pension fund had decided to increase its credit exposure.
We also wrote in June that the £3.9bn Lincolnshire County Council Pension Fund had set its allocation to UK government bonds at 0 per cent in its new strategic asset allocation. At the same time, it lifted equities to 50 per cent from 45 per cent, while bumping up its cash allocation to 2 per cent from 1 per cent.
Even before the Iran conflict earlier this year there were signs that investors were growing more wary of the possibility of future disarray in bond markets.
Research published by Edelman Smithfield at the end of last year revealed that 97 per cent of institutional investors expected that a sovereign debt crisis in at least one developed market would be a likely scenario over the coming three years.
In the same survey, more than nine in 10 (91 per cent) said they expected a rise in high-yield default rates in the coming 12 months.
“[Investors are] often forced sellers of 'fallen angels' [bonds] that are victims of periodic downgrades by rating agencies, creating opportunities for active managers to sell them [other] high-quality bonds”
Managers and investors react to the rise in yields
Rajan says that in times of market stress, some types of highly regulated asset owners, including central banks, commercial banks and insurers, tend to be forced sellers as yields rise.
For this reason, active fixed income managers can perform well as investors hunt for other types of fixed income.
"[Investors are] often forced sellers of 'fallen angels' [bonds] that are victims of periodic downgrades by rating agencies, creating opportunities for active managers to sell them [other] high-quality bonds," Rajan says.
Bfinance wrote in its Q2 Manager Intelligence and Market Trends report, released in August, that broader multi-sector fixed income strategies have "[featured] prominently, particularly among investors seeking incremental yield with greater flexibility".
Amid the turmoil in bond markets, some managers have launched broader active credit mandates with a more global outlook, which they say allows for greater bandwidth to assess risk and opportunity in global credit markets.
At the end of July, TwentyFour Asset Management launched a new multi-asset credit fund, which it said was created given "evolving client needs and the market environment".
"Investor demand for dedicated multi-asset credit solutions has increased significantly, particularly from clients seeking higher income and more targeted exposure to global credit markets," the manager explained on the fund's launch.
Eoin Walsh, partner and portfolio manager at TwentyFour, said the market environment meant investors were "looking for solutions that can deliver income without sacrificing flexibility".
"A pure credit approach allows the portfolio management team to focus on where we see the strongest risk-adjusted opportunities," he added.
In August, Candriam announced it was repositioning its Bonds Total Return Fund into a broader Bonds Global Alpha Fund, which it said would combine "active directional long and short positions primarily across global interest-rate and sovereign credit markets, complemented by relative value strategies".
Nicolas Jullien, global head of fixed income at Candriam, said the move reflected a "broader opportunity set" in a fixed income environment "driven by greater interest rate dispersion, divergent monetary policies and valuation differences across regions and sectors".
Not all investors have shown signs of pessimism towards UK government bonds. In July, we reported that the £3.9bn Falkirk Council Pension Scheme had lowered its allocation to equities while increasing sovereign bonds.
It awarded a short-dated gilts mandate to Legal & General, worth £100mn, while also increasing a separate index-linked gilts allocation by £17mn. The £7.4bn Leicestershire County Council Pension Fund has also increased its strategic allocation to UK government bonds to 5.5 per cent, from 3.5 per cent, in its 2026 strategy, with investment adviser Hymans Robertson citing attractive gilt yields as a reason for the increase.
The pension fund invested £140mn in Legal & General's All Stocks Gilt Index Fund in three tranches in June and early July. In a July investment update to Leicestershire's pensions committee, LGPS Central said the phased implementation was designed to "take advantage of current yield, while reducing the impact of potential market volatility".
Hymans Robertson said in minutes from the pension fund's January investment strategy review that LGPS funds had previously avoided gilts largely because of "poor returns over the last decade", but that market conditions had since improved.