Passive UK credit allocations are ineffective in meeting DC member needs, says AXA IM

DC default funds should follow DB schemes and insurance companies in moving away from passive corporate bond allocations to improve climate resilliance and member outcomes, according to AXA Investment Managers (AXA IM). 

Fixed income remains a vital part of DC members’ at-retirement investment portfolio, often ranging between 30 per cent to 60 per cent of the default strategic asset allocation for large master trusts and single trusts. Within this, passive UK corporate bond mandates form a large part - an approach AXA IM believes to be ineffective for meeting member needs. 

Sebastien Proffit, Head of Portfolio Solutions, Fixed Income at AXA IM, says: “DB pension funds and insurance companies have been moving away from passive UK corporate bond allocations in recent years. They have recognised the structural shortfalls, lack of flexibility and material negative impact that turnover costs and forced selling can have on strategy performance - yet these allocations remain a mainstay of many default designs in DC pension portfolios.”  

“We are encouraging UK DC schemes to reconsider this approach and think about how this important allocation can be improved.” 

AXA IM believes that a more global focus – with the ability to implement climate-aware objectives – would improve member outcomes by providing both steady income and stable growth opportunities. 

It argues that while the spread and average credit rating for UK and global corporate credit indices may be broadly the same, the 20x expansion of the investment universe achieved through inclusion of the US and EUR markets has huge implications for both the liquidity of the bonds held and the diversification of risks.  

Proffit said higher liquidity would reduce trading costs which, while not being shown directly in fund performance, could positively impact a credit portfolio that is being used for regular drawdowns in retirement. Additionally, a greater level of portfolio diversification across issuers and regions should reduce volatility and drawdowns. 

“There are clear financial benefits for DC schemes and members to switching from a passive UK to a global corporate bond allocation. The global universe can offer greater diversification, liquidity and more stable performance which can boost returns for members as well as reducing the dispersion of performance between them,” he says. 

“The Sterling corporate bond market has had consistently higher levels of volatility compared to the Global Credit market, which can create a larger risk for individual members when they are drawing cash in retirement. At a scheme or trust level, this could lead to greater distribution of returns between different members, depending on when they decide to draw income.” 

AXA IM also pointed to structural concerns of a passive approach, with the structural bias to be lending the most money to the most indebted sectors and issuers which does not represent a prudent way to allocate money.  

It argues for a more blended approach, such as a buy and maintain credit strategy which seeks to use the same fundamental credit research and skills as active management but with the low-cost edge of passive management, can overcome these issues.  

“Adopting a buy and maintain approach can avoid the inefficiencies and risks inherent in tracking an issuance-based index whilst harvesting the maximum amount of yield available in the credit universe as cheaply as possible,” says Proffit.  

“Not only can moving away from a passive approach provide more opportunities to lock in higher yields through relative value investment opportunities, it can also unlock the ability to implement climate-aware investments, helping schemes or trusts better meet their regulatory and member outcome requirements. We believe passive strategies are subject to higher climate-related risks and have a lower impact on the climate transition.” 

Proffit concludes that even when looking at index allocations, expanding DC members’ universe from UK to Global corporate bonds could increase the stability of returns for members by accessing a much broader universe of issuers and a more balanced allocation of risks.