SH: The perils of index tracking bonds

Index tracking bond funds based on commonly used indices are widely used by pension schemes as the low risk assets in their investment strategies. This is especially the case for smaller pension schemes. We test the presumption that index tracking bond funds are low risk assets by looking in more depth at the characteristics of these funds.

Key findings are:

1.That the durations of index tracking funds change materially over time

2.The degree to which index tracking funds ‘match’ pension scheme liabilities can also vary substantially

3.The vast majority of schemes do not explicitly consider or manage these issues
Why do pension schemes use passive bond funds?
It is common amongst UK pension schemes to have a strategic asset allocation to bonds and often to passive UK government bond (gilt) funds. These index tracking funds tend to track over 5 year, over 15 year and all stocks gilt indices.

The historic rationale for this type of allocation has been that these funds generally tend to behave similarly to pension scheme liabilities. Liability values, as calculated by Scheme Actuaries, are sensitive to changes in interest rates and inflation expectations. So too are gilts. Therefore the assertion has historically been made that:Fixed interest gilts are sensitive in value to changes in interest rates. Therefore they can be used to match fixed liabilities that are also sensitive to changes in interest rates