Pension funds that take a passive approach to corporate bond investment are failing to address a hig...
Pension funds that take a passive approach to corporate bond investment are failing to address a high level of risk that could damage their solvency levels, according to Britannic Asset Management.
Fiona Ross, head of segregated funds at Britannic, said: 'If a fund is trying to immunise itself against future liabilities in line with FRS17, then it is trying to match them with AA-rated corporate bonds.
'The problem with a passive bond portfolio that tracks an index is that it assumes the AA-rated bonds bought on day one will always remain the same grade. This is far from the case due to downgrades.'
The number of downgrades has been increasing in the current environment as the financial strength of many companies has deteriorated.
Ross added: 'Standard & Poor's statistics show that only 70% of AA-rated bonds are still likely to be AA-rated in three years time. And according to Bloomberg Analytics, the market price of a corporate bond that is downgraded from AA to A falls by 4.14% on average.'
This poses all sorts of issues for pension schemes trying to match their liabilities through passive funds, according to Britannic. Ross said: 'A passive portfolio could be instructed to sell a bond immediately it is downgraded and replace it with other AA bonds, but this then locks in a loss ' a loss that an active manager would have had an opportunity to avoid in the first place.'
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