As pension funds re-evaluate their approach to bond investing, consultants all around European are trying to help their institutional clients in this changing scenario where low interest rates make equity investments more attractive.
Fixed income investing is part of the strategic asset allocation that consultants propose to their clients. “Once we have defined in which kind of assets the client should invest we decide about the strategic weight,” says Hans-Juergen Reinhart, partner at RMC Risk Management Consulting in Frankfurt.
“The main point that concerns us within bond investments is how to bridge duration gap between the liability duration and the bond portfolio duration of the client’s assets. Generally, the liability duration is much longer than the portfolio duration signifying a high risk for the investor,” Reinhart says.
Once the duration decision has been taken, they look at how they can enhance the return of the bond portfolio. “After the introduction of the euro, intermarket spreads on government bonds have narrowed down a lot and there are basically no more opportunities to profit from government bond investments within the Euro-zone.”
The trend in Germany, as well as in the rest of Europe, is to move from government to corporate bonds. “However, many German clients are still reluctant to invest in bonds below investment grade even though we as consultants thinks that good opportunities in high-yield bonds at reasonable level of risk exist as long as the diversification in such portfolio is wide enough,” says Reinhart.
He comments that there is a negative correlation among pure credit returns and the returns of high duration government bond portfolios which favours portfolio diversification. “But in order to profit from the advantages of credit-spread portfolios in the investment and speculative grade credit markets, it is of primary importance to implement the appropriate investment approach.
“We can definitely say that most German pension funds have moved into euro bonds and some into Europe ex-euro bonds. Overseas investments are still only favoured by the very large and experienced pension funds.”
In France, consultant Arthur Andersen advises its clients on global investment strategies in the very long term. “We advise our clients keeping in mind that the future cash outflows should be matched by investment returns,” says Patrice Cardon, head of actuarial and insurance consulting in Paris. “We have also been asked to develop a model for a portfolio including index-linked bonds. The aim of this work is to assist pension funds in determining their strategic and tactical allocation of investment to minimise the risk of being bankrupt at any time over a period of 100 years, with alternate scenarios based on various policies of profit-sharing with pensioners and active members. The client is the able to have a view of their solvency margin on a prospective basis, depending on its profit sharing strategy,” she says.
Jaime Albo, senior consultant at Towers Perrin in Madrid, describes the situation of bond investing in Spain: “The trend that pension funds are following in terms of investment has been changing during the last three years,” he says. “Before that, 90% of asset allocation was in fixed income, because interest rates were very high. Now we have around 25% in equity and the rest in bonds, which is quite a big change in such a short period. At present, with interest rates being so low it doesn’t make much sense to put much weight in fixed income, and pension funds are taking more risks.
“Although fixed income investments in Euroland are increasing, the majority of the investments are in Spanish fixed income.”
Outside Euroland, in the UK, the driver pushing pension funds towards fixed interest is the minimum funding requirement (MFR). “The idea is that every pension fund has to prove solvency every year, and if it doesn’t it has to bear in mind that after a period of time it has to be solvent,” says Geoff Arnold, actuary at PIFC consultants. “If you have a scheme which is quite old – where, for example, half of its members are already retired, the natural asset to match that liability is fixed interest. Pension funds have to match their assets and liabilities so they don’t get nasty surprises.”
One of the products that UK pension funds are increasingly asking for is corporate bonds.
“What is pushing people towards holding corporate bonds is the fact that they do have a high yield or high return so that will be an issue to look at. If we see a scheme which is pretty well funded we could be tempted to tell them to use corporate bonds if they want they want to match their assets and their liabilities, he says.
“Although in the past it’s been said that equities give higher returns than fixed interest stock, there is no guaranty that this is going to be true for the next 10 years.”
Regarding UK pension funds’ investing in euro bonds, Arnold comments: “The exposure to euro bonds is price-driven. If you are an investor you have to invest where you get a higher return. However, the problem with euro bonds right now is the weakness of the euro.”
In Switzerland, pension funds are asking consultants how to deal with the very low yield available on Swiss bonds, that at present is not reaching the 4% ‘mental benchmark’ that some pension funds have as their objective. Dominique Ammann, partner at PPC Metrics in Zurich, says that they are trying to improve long term returns for Swiss pension funds through a higher international equity exposure and higher Euro-zone fixed income investing. When this is not possible because of a low risk tolerance, they advise their clients to use ‘volatility reserve’ to cover a return shortfall.