Expectations regarding “Abenomics” have sent the stock markets soaring. Pension funds have increasingly been reporting cumulative returns of over 10% thus far in the fiscal year, and the atmosphere among pension investors has brightened considerably for the first time in quite some years.

 At the same time, the equity upswing has spurred concerns at some funds over the risk of a bond yield rise, since many have been laggard in reviewing their bond strategies even after slashing their equity weighting and raising their bond holdings over the past few years. We take a look at pension fund fears of upside yield risk despite 10y JGB yields still at ultra-low levels of less than 1%.

Fears of high bond ratio

The Government Pension Investment Fund (GPIF) is reconsidering its basic portfolio at the request of the Board of Audit. Speculation has emerged that the fund may seek to lower its high ratio of domestic bond holdings on yield concerns. In fact, GPIF’s basic portfolio assumes much higher JGB yields than current levels. A significant reduction in bonds is unlikely unless the fund changes those assumptions or renews the portfolio’s entire structure. With 10-year yields below 0.7% as of late February, the fund has not reached a conclusion as yet.

Some corporate pension funds also having high bond weightings have expressed concern recently over a potential rise in yields from their current historic lows. Though not at GPIF levels, bond weightings at corporate funds have been raised increasingly in recent years. This is due partly to systemic changes such as the introduction of retirement benefit accounting standards and a reduction in guaranteed yields, as well as to the deterioration in the investment environment since the Lehman shock and Eurozone debt crisis, prompting the funds to move in force to suppress overall asset risk. As a result, their equity ratios, which stood at one point at over 60% (cumulative domestic and overseas), have been greatly reduced, and the money has been put instead into alternative investments and bonds.

The Pension Fund Association’s annual report reveals that corporate pension funds have gradually boosted their domestic bond weightings from a low of 20.1% in FY03. The ratio had reached 27.2% in FY11, the highest level since FY92.

Pension funds have generally become more selective in their equity investment as they rein in their ratios, but many have failed to review their bond strategies despite the growing proportion of bonds in their portfolios. Some have sought new investment opportunities, but there has been a tendency to relegate due diligence on bond investment to the back burner.

One defined benefit fund that has shifted from stocks to bonds and alternative investments says that there is little serious threat of a yield upswing. Still, it recognises that an upturn in yields would generate the biggest adverse impact on returns for bonds with longer maturities, where it has concentrated much of its bond investment efforts. It is now planning to reduce this ratio.

Diversification in bond portfolio

The situation is similar at employee pension funds (EPF). Tokyo Jitsugyo EPF will adopt a new asset mix next fiscal year. It will rethink its fund managers and allot new funds to life insurer general accounts, where dividends are assured even if bond yields should rise. It will lower its equity ratio from 50% to 30% and increase the number of its fund managers in a bid for diversification.

The fund divides its assets broadly into benefit reserves and profit-generating assets. The former are put into domestic stocks and bonds as well as long-term assets such as real estate promising stable income over a prolonged period, while the latter go largely into stocks. From FY13, it plans to invest ¥58bn ($605m) into domestic bonds of its ¥120bn in total AUM, including investments like JGBs and yen-hedged bank loans as well as general accounts.

The Ministry of Health, Labor and Welfare is preparing legislation assuming an elimination of EPF. The contents of the legislation are not yet decided, so the timetable for abolition and conditions for EPF that will be allowed to survive are uncertain. As such, EPFs that were reviewing their policy asset mix, not knowing if the system will even be preserved, have to maintain their existing asset mix based on long-term investment. More and more funds are diversifying their investment, such as buying more enterprise bonds or substituting relatively high-earning overseas bonds for domestic bonds with the use of forex hedging.

Domestic bonds are not the only instruments at risk of a yield rise. In the US, where a swift monetary easing helped spur a turnaround in the real economy, there is growing speculation that quantitative easing is approaching an end.

Among the overseas bonds in pension fund portfolios, yields fell particularly sharply on high-rated bonds like US Treasuries and Bunds in the wake of the Eurozone debt crisis. Meanwhile, yields shot upward in Spain and Italy on concerns over fiscal reform, prompting Japanese investors to pull away. Thus, the weighting of traditional government bond investment is trending downward, replaced by higher acquisition of investment-grade corporate bonds, high-yield bonds, bank loans and emerging market bonds.

High-rated corporate bond yields are in decline as with major government bonds, but as yields on the other instruments are still relatively high, investors are increasingly accepting credit risk and liquidity risk.

More pension funds are also adopting alternative strategies, such as adjusting their weightings in line with a nation’s fiscal health or GDP or allowing fund managers to change their domestic and overseas bond weightings more flexibly. Many have also turned to absolute return strategies.

The full version is available in the March-April edition of IPA