The world’s economy is already recovering from the damage inflicted by the lockdown measures imposed to contain the spread of COVID-19 in 2020.

Institutional investors may be relieved, but they should never lose sight of the most daunting challenge, which is to manage portfolios successfully in the face of high levels of systemic risk. 

The May 2021 edition of the European Central Bank’s Financial Stability Review shows that risk in the financial system remains elevated, despite the economic recovery. 

The ECB argues that the stress  of March 2020 showed evidence of systemic risk stemming from the non-bank financial sector, which includes pension funds and other institutional investors. Money market funds and open-ended investment funds faced pressure, due to liquidity mismatches and over 200 Europe-domiciled investment funds suspended redemptions during the period.

Quick and decisive action by central banks avoided a widespread liquidity crisis, but the ECB notes that risk-taking behaviour has resumed in recent months.  

In recent years, non-banks have extended growing amounts of credit to firms with weak fundamentals, according to the ECB. More than a quarter of non-banks’ debt holdings are subject to a negative credit outlook or credit rating agencies, while around half are BBB-rated. In their relentless search for yield, non-banks have increased the duration of their debt portfolios.

This may seem a natural, and perhaps inevitable, consequence of decades of low interest rates. The policy response to COVID-19, which has consisted of massive fiscal and monetary stimulus, has exacerbated the problem. The new, unwelcome, development is that the quick post-COVID recovery has caused consumer prices and yields on US Treasuries to rise. This rise in US yields has spilled over, though modestly, into Europe. 

Carlo Svaluto Moreolo

A more sustained rise in inflation and interest rates – both of which are not out of the question – would cause serious damage to institutional portfolios, and threaten the stability of the financial system. But even without rising interest rates, further economic stress, in the absence of fiscal stimulus, could cause a repricing of credit risk, with systemic consequences. 

The ECB and other global institutions are taking steps to address this challenge, by trying to strengthen the macroprudential toolkit. The Financial Stability Board (FSB) will propose to increase liquidity requirement for money-market funds and potentially institutional investors including pension funds and insurance companies. The review of the EU Solvency II framework, in particular, could seek to address systemic risk.

It is virtually impossible for investors to insulate themselves from systemic risk. However, in order to protect their portfolios, investors should keep abreast of the relevant regulatory changes and challenge investment managers to provide appropriate fund structures and due diligence on credit assets.

It is also crucial for investors to ensure that their portfolios, especially the fund stakes they own, can withstand liquidity crises. Disciplined liquidity stress-testing and scenario planning are fundamentally needed.

The search for yield may not be over, but investors must be extremely cautious about where they seek to find it. The stability of the entire financial system, and the world’s economy, is at play.  

Carlo Svaluto Moreolo, Senior Staff Writer,