All endowments and foundations are faced with a twin challenge. On the one hand, they need to maintain the value of their capital. On the other, they need to generate sufficient return to sustain their charitable mission.
A central objective is to achieve returns above inflation, protecting capital and delivering cash for their vital day-to-day work. Targets vary, but many endowments and foundations aim for returns of inflation +4%. Such a target may not always be achieved, but until recently ‘inflation plus’ has been achieved across a range of investors and investments.
In the five years to December 2021, a global portfolio with a classic 60:40 equities and bonds split would have risen 9.8%1. But in 2022 there was a sharp reversal. Inflation soared to double digits. Meanwhile, the FTSE World Index dropped 7.2% and index-linked gilts, typically seen as a hedge against risk fell 33.6%.
Overall, in 2022, a 60:40 portfolio would have fallen in value by 17.7%2.
After the last year, some endowments and foundations will be seeking to rebuild lost capital, without taking unacceptable levels of risk. Those that made good returns in the previous five years may be more comfortable with their capital level.
But whatever the unique situation of each endowment or foundation, they will all still be looking for that inflation plus return.
Economic and market uncertainties remain, but the outlook is far more stable than six months ago. There is an opportunity for endowments and foundations to reassess their investment strategies, and a key aspect of that reassessment should be to take a fresh look at fixed income.
Looking more closely at gilts could be particularly appropriate for endowments and foundations with lower return targets, or those that have weathered the last year well, and so are less in need of re-building capital.
Gilts naturally offer a lower risk profile, but the wider fixed-income market – from investment-grade to high-yield corporate bonds – may also offer opportunities to control risk. The exact balance will depend on an endowment's recent performance, its risk appetite and its future targets.
In the UK Consumer Price Index, inflation has begun to recede from its October peak, but the headline figure for January of 9.2% may still seem daunting. However, it is essential to remember that this is a backwards looking figure.
Energy prices are receding and with them the overall inflation rate is declining. The Bank of England is forecasting annual CPI inflation in the first quarter of 2024 to be 3% and gilt markets also indicate a sharp decline in inflation expectations.
It may be argued that recent events have shown fixed income to be far less effective in countering risk than had been thought, and indeed some endowments suffered sizeable falls in the value of gilts last year. However, this is not a case against gilts. Such losses were typically due to the maturity of the gilts being held.
A thirty-year index-linked gilt will provide capital protection – over thirty years. In periods of short-term volatility and rising yields, they may perform very badly. When planning strategies over the shorter term, including the objective of generating ongoing income for charitable work, long-dated gilts are unlikely to be the best option.
If the selection of gilts includes a full analysis of their maturity date and their potential effect on short-term as well as long-term security, then fixed income can be a powerful asset for controlling investment risk.
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