Magazine article Public Finance

Playing It Safe

Magazine article Public Finance

Playing It Safe

Article excerpt

PUBLIC SECTOR PENSION funds are feelingthe strain as they try to reduce their deficits. With interest rates remaining at extraordinarily low levels, the Consumer Prices Index more than double the Bank of England's target, and rises in both VAT and commodity prices, what can public sector investors do?

Some might take higher risks to achieve higher returns, a perilous strategy in today's wildly uncertain global macroeconomic outlook. We believe senior, secure and safe inflationprotected investments are a much better option at present.

The most obvious of these is inflationlinked government bonds (gilts). Passively managed index-linked gilt funds yield remarkably little but actively managed funds can offer more. Over the past three or four years, an unprecedented amount of new gilt issuance has created a liquid, volatile and inefficient secondary market for these inflation-proofed bonds. This allows skilled active managers to exploit several opportunities to beat the market. Consistently outperforming a passive fund by 1% per annum is feasible, without taking on high risk.

Index-linked corporate bonds are the next logical opportunity. Unlike the gilt market, a relatively small number of corporate 'linkers' are issued, and they do not tend to trade in the secondary market at all. Nonetheless, these bonds can be a suitable source of inflation protection as they offer superior yields to index-linked gilts. However, investors are subject to the risks that a lack of diversity can bring to a portfolio as only a few sectors issue these bonds, such as supermarkets and utilities.

Another is to buy high-quality properties (such as prime-location supermarkets) and rent them back to their previous owners on an inflationproofed basis. Many local authority pension funds have invested in this way. The inflation-linked rental payments resemble index-linked corporate bonds in terms of cash flows and also give the owner the potential for a capital gain.

Furthermore, if the tenant defaults, the property can be re-let. Bond investors, by comparison, would be lucky to get 40% of their initial investment back in a default. The returns on long leases can also be far superior to comparable bond investments. Only some investors have the skills to ensure the correct documentation is in place, and so due diligence on managers is essential. …

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