A huge market with limitations
The most suitable match for the liabilities of continental Europe’s pension funds has traditionally been European fixed income: specifically European government debt. This is still the largely the case. Almost two thirds of the average Euro-zone institution’s portfolio is invested in EMU government bonds. A UK/US style of equity culture is still some way off in Europe.
However, there has been a significant move down the credit curve as European institutions have moved some of their portfolio out of government into other asset classes, notably investment grade corporate debt. They have also moved to higher risk government debt such as the ‘converging market’ debt offered by accession countries like Poland and Hungary.
The yields from these spread products are important because they provide the returns that Europe’s pension funds and insurers need if they are to rebuild their assets, depleted by a three year bear market in equities.
Although Euro-zone government debt remains the core of continental European institutional portfolios, investors are able to diversify within this asset class. One way is by investing in the higher yielding countries of the Euro-zone. Auke Koopal, head of fixed income at Lombard Odier Darier Hentsch (LODH) in Amsterdam, covering all euro and European fixed products, says: “We see core government debt as our starting point. We want to add value within this basic portfolio environment, and we can do this by identifying the high yielders in the EMU area. At the beginning of the year the higher yielders for us were Greece and Italy, especially at the long end, while we were underweight in Germany, France and the Netherlands.
“This positioning has contributed to the performance of the basic EMU government portfolio. Italy and Greece have done better than Germany. So right now is the moment to switch back into the core EMU countries.”
However, as a general rule, pension funds will prefer investments denominated in their own currencies – euro, sterling or dollar - to match their liabilities. Nick Horsfall, senior investment consultant at pension consultants Watson Wyatt in the UK, points out: “Essentially, bonds are there to reduce risk, and therefore your starting point is that you would want to hold bonds that look like the liabilities you have to pay. if you were an investor in Europe they would be euro-denominated. What tend not to be favoured are bonds denominated in other currencies. The rationale for that is that when you’ve ex-ed out currency hedging the yield pick-up is normally insufficient to pay for the curve risk.”
Yet the diversification benefits of non-euro denominated government debt may be worth the cost. Keith Swabey, client portfolio manager at international in the fixed income group at JP Morgan Fleming Asset Management (JPMF), suggests that institutional investors should look to global government debt if they need to diversify. “Most European companies with European liabilities currently have placed most of their money in the European government index box. If they want to diversify, they can go global but stay within government by adding US and Japanese government bonds. This is one of our preferred routes, because we think that by adding geographic diversification you can decrease risk.”
Other options for investors who do not want to move out of the Euro-zone include more actively managed Euro-zone government debt. “In general the philosophy of Lombard Odier has been that you need government bonds for stability in your portfolio and a more certain income stream,” says Koopal. “But in today’s circumstances especially, they don’t give the yield that you would seek to meet your future pension liabilities.”
To improve the yield from governments, LODH offers an ‘enhanced government’ approach. This is one-dimensional model – it looks only at interest rates – based on a quantitative, statistical analysis of the drivers of the bond markets in terms of yield curve movements. “Tracking error is created through overall duration positioning and yield curve positioning. If you expect the yield curve to become steeper or flatter you can position yourself to profit from that,” says Koopal.
“It is an approach which you can make as active as you wish. You define and determine the tracking error in this approach to any level you wish.”
Another active management option is the ‘fundamental’ approach to government debt. This model considers other parameters besides interest rates. “It is a top-down, approach in which you study economic and other factors, make forecasts of future yield levels and set your portfolio’s active positions in terms of duration and yield curve,” says Koopal.
Although both approaches add value to the management of government bonds, their potential is limited by the potential of government bonds themselves, he adds. “Through the enhanced or fundamental approach, you can implement a certain tracking error and, given your information ratio, you can add value versus the government bond index. However, the outperformance you can achieve will be limited if you only focus on government.”
Another option for European investors who want to add value to their core Euro-zone government debt portfolios is to add in some European ‘converging market’ debt. Converging markets include the first wave EU accession countries which become full members on 1 May 2004 – Poland, Hungary, Czech Republic, Slovak Republic, Slovenia, Estonia, Latvia, Lithuania, Malta and the Greek part of Cyprus – and second wave accession members expected to join in 2008 – Croatia, Bulgaria and Romania. Turkey and Serbia could join in 2011 as part of the third wave.
These markets are attractive because they offer clear diversification benefits. They provide high returns, relatively high volatility and low correlation with EMU government bonds. They have the added advantage that with eventual euro membership currency risk will disappear.
Sjacco Schouten, analyst and portfolio manager, emerging markets fixed income at LODH in Amsterdam, says that ‘first wave’ converging markets offer the best opportunities. “We have done some risk return analysis, adding Poland, the Czech Republic, Hungary and the Slovak Republic, which are the main local currencies available to us. This showed that you could gain some diversification benefits by putting these markets into a standard EMU government bonds portfolio, so you could reduce risk and increase your expected returns.
“The high yields the markets offer – especially a couple of years ago – will more than compensate for any currency risk. So the positive spread these markets offer will add value to any government bond market.”
Schouten has analysed Polish zloty bond market returns in euro terms, taking account of all the currency depreciations or movements. “The average return of the last five or six years has been something like 17% while the standard deviation of those returns has been 14%. And looking at that 14% most of it comes from currency movement.
“That’s a very important aspect. If you invest in these markets you must ensure that you hedge the currency,” he says.
“You have to take an active approach to currencies if you want to limit the volatility of the returns. And most institutional investors and pension funds do want to limit this type of volatility.”
The other route that European pension funds can take is to move away from governments altogether but to remain within the Euro-zone; In other words, to switch from a governments-only benchmark to an aggregate, which includes agencies such as Pfandbriefe and investment grade credits such as corporate bonds and asset backed mortgages.
There are respectable returns from diversifying into an aggregate fixed income portfolio, says JPMF’s Swabey. The JPMF fixed income team compared risks and returns of European governments and aggregates between January 1999 and December 2002. “In European governments the risk that you’ve run, the standard deviation, is about 3.5% and you’ve earned about 4.8%, whereas with European aggregates the risk is about 3.2% and you’ve earned about 5.1%. So adding an aggregate benchmark away from the government benchmark works out over the medium term.”
However, typical European asset allocation is still heavily skewed into governments, he points out. “If you could invest across Europe, not just Euroland, approximate percentages are 62% government, 11% agencies, and 25% corporates. But the average credit rating of that group of assets is still AA – so you haven’t taken a big decrease in credit ratings.
“If you are a euro-denominated investor, you are more restricted because you are excluding countries like UK and Sweden. The percentages in this case are approximately 68% government, 11% agencies and 15% corporates.”
The heavy preponderance of governments and quasi-governments in European benchmarks means that investors are less able to diversify in Europe than elsewhere, says Swabey. “It’s actually quite limited in terms of diversification because the vast majority of the European asset base is basically government or agencies and they trade in a very
similar fashion. Whereas in the US you get a much larger percentage of non-government assets.”
European credit markets are not a large component of the aggregate benchmark. On a pan-European basis, they account for 25% of the aggregate against governments and agencies, which account for 73% to 74%. However, they provide an increasingly important asset class for European pension funds, says Patrick Hendrikx, head of global credit at F & C Management Limited. “For a pension fund, being a long term investor, you should have a substantial portion of investment grade credits in your portfolio. There are three reasons for that. The first is that over a longer term it provides outperformance versus governments. For example, if you look at the US market, you can see that over a 10 year period credits outperformed treasuries by on average 0.9 to 1 %.
“Second, the correlation, the way credits and equity markets behave, is quite different. So if you add this to your portfolio in addition to govvies and equities you optimise the return/risk for the portfolio. And that’s always what a pension fund is looking for, adding to asset categories so they can have more return and keep the risk the same.
“Third, when you look at measures of return versus risk for different asset categories, like a Sharpe ratio or an information ratio, you can see that investment grade credit has a very good information ratio in comparison to other asset categories.”
Corporate bonds have performed well against government debt, he says. “They have outperformed by 80 basis points. The return up to the end of May was 5.14% against a return of only 4.34% by the government index. The current extra yield that you can get from credits is still around 70 to 75 basis points, and we expect that to be the return for the remainder of the market this year.”
However, the European investor who moves further down the credit curve into non-investment grade, or high yield, European corporate bonds faces two problems. The first is that the European high yield market is relatively under-developed, at least compared with the US market. The second is that it lacks a broad spread of industry sectors and has tended to be concentrated on telecom and technology.
John de Garis, head of alpha for the European Fixed Income team at C redit Suisse Asset Management (CSAM) in London, says: “The problem that we’ve had in Europe is that the European high yield market effectively blew up. Default rates were very high and there were a lot of telecom and technology companies that went into restructuring.
“People are now coming back to the European high yield, but to get the full spread of exposures to industries we use the US high yield market as well. Without dipping into the US high yield market we can’t really get the diversification and that’s important for that kind of asset class. You do need to spread your risk.”
Demand for corporate debt is currently strong, he says, and for the past six months there has been an imbalance between supply and demand. “A lot of that is down to new types of instrument. The growth of credit derivative market has created a new source of demand and we think that for the foresseable future is going to continue.”
One of the attractions of credit derivatives are that they give the investor access to a much wider range of credits, says Horsfall of Watson Wyatt. “Investors can pick the issuers they think are better value rather than just the ones denominated in their currency. They can also increase diversification. If you are stuck with 250 issuers in sterling of which you like only 80, that limits you to 80 positions. That may feel like a lot but there are some who would say it’s better to have 200 positions and reduce the granularity of the positions there.”
Credit derivatives offer other advantages. Investors can use swaps to separate interest rate exposure and credit term. They can then decide which combinations of credit quality and credit terms are most efficient.
However, Swabey at JPMF warns that investors should not expect too much of them. “We believe that the use of credit derivatives is an incredibly useful extra tool for portfolio management. But it alters the shape of the portfolio marginally rather than opens up a galaxy of new investment opportunities.
“And people should have no illusions as the limitations of them. They give you flexibility and they allow you to do things that, in some cases, are not available in the underlying bond market. For example, if a company has a five year bond but you want to invest in that company for 10 years you can’t do that in the bond market because the 10 year bond doesn’t exist. But if that company has a 10 year loan or perhaps a convertible, you can use the derivative market to give you 10 year exposure. But have no illusion where the risk lies. It lies with the company for the next 10 years.”
Perhaps because of the perceived risks, pension fund consultants have had little success selling credit derivatives to their pension fund clients. Horsfall says credit derivatives have yet to capture the imagination of Watson Wyatt’s UK pension fund clients.
“That being said, a number of trustee bodies are taking advantage of the credit default swap market and the credit derivatives market and we expect it to become more commonplace in the medium term.”
The strong demand for credits from European pension funds may also be driven by an interest in what has been termed ‘new balanced’ mandates: that is, an asset allocation that matches liabilities more closely than the traditional balanced mandate. Rod Paris, head of global bonds, at Standard Life Investments in Edinburgh, says: “There is a tremendous interest in what we would describe as liability-driven investing. This is a much closer appreciation of the liability profile that the assets are there to match. That is causing a reappraisal in terms of the equity/fixed income balance that is appropriate for European investors – remembering that European investors come from a relatively low equity and high fixed income base.
“We are seeing this perspective growing in terms of the very customised mandates. These won’t be necessarily against standard benchmarks, but are going to be unique to the particular liability profile.
Another driver of the demand for European fixed income is the new interest in total or ‘target’ returns. “In Europe the interest isn’t in relative performance but absolute performance,” says Paris. “We see Europe as a LIBOR plus market. There is a strong demand for cash and enhanced cash products. We already have an AAA bond fund which is the lower end of the risk return spectrum in terms of cash plus, and we’re starting to run LIBOR plus 100 mandates, which is moving up the risk spectrum.”
Paris says that it is only a matter of time before pension funds demand more aggressive target mandates. These could be a blend of credit and equity strategies combined into a cash fund.
CSAM’s de Garis suggest that interest in total returns is likely to grow as interest in benchmarks wanes. “The switch to aggregate benchmarks has not been as big as we probably expected a year or so ago. There is some move more towards specialised benchmarks, such as corporates alone or even collateralised.
“But given that yields are so low, the next thing is the move towards more total return style products rather than benchmarked products, using LIBOR or deposit rates as the benchmark.” CSAM already offers a product with a LIBOR plus 250 hurdle.
The new appetite for liability-driven investing and target returns is part of a broader drive by pension funds to squeeze the most out of their fixed income portfolios. Horsfall of Watson Wyatt says that a typical refrain from clients is that they want to make their bond assets work harder. “That means that you’ve either got to be very bright and work out whether index-linked are going to outperform fixed or UK going to outperform Germany or long-dated going to outperform short-dated. Or you’ve got to start using credit-related instruments because these things are priced to outperform the credit risks. So we are seeing a lot of more of clients ask us or their managers to use credit-related instruments.”
There has also been a change in the way fixed income is perceived and a realisation that, actively managed, a bond portfolio can produce total returns that will go some way towards repairing pension funds’ depleted assets. “Some people will always take the view that bonds will never return as much as equities and therefore I only hold them because I have to,” says Horsfall. “But there is also a growing number of people who understand that by giving their asset managers greater flexibility they can get back some of the expected outperformance from equities through carefully tailoring their bond mandates.”