Kyushu Electric Power needed a portfolio that could withstand the adverse impact of a stock market decline and yen appreciation on investment yields. As a result, in its latest review of investment policy, it has lowered its ratio of equity holdings by 10% of total assets while raising its bond holdings by 8%. It has also begun investment in super-long bonds and is reinforcing its hedging functions using managed futures and other approaches. The fund’s management is also concerned about the effect of slumping pension investment returns on its fiscal year earnings statements. After close discussions with company management, the fund managers have constructed a portfolio that will not significantly affect the company’s earnings performance.
Kyushu Electric Power, which operates a defined benefit pension plan, has pursued a diversified investment style for its asset holdings, while maintaining a certain level of yield return over the long term. In common with other companies, management is worried that changes to the funded status of the pension scheme could have repercussions on its core earnings. The fund management team has taken these concerns into account by looking anew at the basic portfolio and laying down a system aimed at suppressing annual pension fund volatility. This is the company’s first such revision since the financial crisis.
The company has a pension portfolio of ¥300bn (approx $4bn), so changes in its investment performance can have a significant impact on core earnings. A loss in the portfolio can force management to take a chunk out of company profits. Hiroaki Adachi, Senior Investment Officer in the Accounting & Finance Department, remarks that the company has become even more concerned with the pension fund than ten years earlier, when it posted three straight years of losses from 2000.
The Accounting and Finance Department felt that the new portfolio should be more carefully aligned with management concerns. In the past, the company president has decided the general guidelines for pension investment, which were then simply reported at the board of directors meeting. These will now be discussed as well with the vice president and other executives. Whereas reports before tended to be after-the-fact announcements, fund managers will now offer information on the current state of the fund in monthly e-mails. They are also prepared to act immediately if there are requests or opinions from management.
In order to avoid the risk of a major slump in share prices, the fund management team considered the advantages and disadvantages of basic portfolios that were 100% devoted to bonds or incorporating a liability-driven investment (LDI) approach. After a comparison of these findings with past portfolio performance, the team decided that equities should be included to some extent and that the portfolio should continue to target expected returns of 2.51% (risk 4.29%). Management did not indicate specific limits regarding the impact on single-year earnings, but the team has promised to give priority to reducing this impact as much as possible.
Basic portfolio restructuring, hands-on portfolio adjustments
Kyushu Electric Power’s investment portfolio is a two-tiered structure consisting of a basic and a hands-on or working portfolio. The former establishes the broad framework of investment assets, while the latter decides the actual assets to be acquired. Any changes in the basic portfolio require the approval of the board, but the working portfolio can be changed at will by the fund management team, within the limits of the basic portfolio guidelines.
The new basic portfolio has been rearranged into four asset classes: stocks, bonds, inflation hedging assets and portfolio hedging assets. Bonds had previously been divided into domestic and overseas bonds, but the latter are fully hedged under the latest changes, allowing them to be incorporated into a single category with their domestic counterparts.
The asset ratio for stocks in the basic portfolio has been lowered by 10 percentage points to 20%. The working portfolio includes domestic stocks (6%), overseas stocks (4%), emerging market stocks (3%) and hedged stocks (7%). All categories other than emerging market stocks were cut by 3-4 points. The domestic equity ratio has been lowered in stages in order to correct the home country bias, but will be maintained at 6% for now.
The firm has positioned stocks as a core asset for generating returns. However, while returns may be high, they can vary sharply year by year, so fund managers will give full consideration to the balance with stocks when considering diversification into other assets.
Bonds, which had been divided into domestic (45%) and foreign (5%), will now make up 58% of the portfolio, an increase of 8 points. Because pension liability discount rates and assumed interest rates are linked with domestic interest rate levels, greater weight will be given to domestic bonds in a pronounced home bias.
In the working portfolio, bonds will be classified as domestic bonds (20%), domestic superlong bonds (5%), life insurance general accounts (20%), and hedged overseas bonds (13%). Domestic superlong bonds are being incorporated for the first time in order to ensure long-term income gains and lengthen pension liability durations (interest rate sensitivity). This refers to investments in long-term bonds with maturities over 11 years and will employ passive funds run by Mitsubishi UFJ Trust (3%) and Mizuho Trust (2%). Risk will have to be diversified in terms of duration, so only half the intended volume has been allocated at first. Adachi says that the team will also consider superlong bonds in it hedged overseas bond investment.
Added portfolio hedging assets: forex hedging for over 80% of foreign currency assets
It is assumed that stocks and bonds will generally produce negative returns when inflationary pressures suddenly rise. Assets used to hedge such cases have been incorporated into the portfolio in a category the company calls inflation hedging assets. The ratio has been set at 15%.
Portfolio hedging assets serve to hedge the risk of a falloff in operating yields in cases such as major impairment losses due to unexpected events such as terrorism or a financial crisis. This ratio has been lifted by 2 points to 7%. Managed futures with little relation to stocks or bonds will be newly added.
The company has not only hedged the risk of the overall portfolio. It has also gradually adjusted its foreign exchange hedging in line with the relentless rise in the yen, in the belief that currency volatility can be as damaging to portfolio performance as a stock market downturn. With the revamp of its basic portfolio, Kyushu Electric Power’s foreign-currency assets now account for 46% of its portfolio. It had hedged 39 points of this for forex risk as of 1 April, bringing its hedging ratio to around 85%. In FY10, it had hedged a mere 15% of its foreign currency assets.
It has switched to hedged products if they are offered by the institutions entrusted with the company’s funds. If there are no such products, Sumitomo Trust Bank, the custodian institution, carries out individual forex overlays. At the same time, there is no hedge for developed or emerging market stocks, which make up the remaining 7% of foreign currency assets. The company feels that hedging all foreign currency assets would itself be a risk since there is no way to know which way the currency may shift.
With the shrinking spread at present between domestic and foreign interest rates, the cost of forex hedging is virtually nil. However, if future changes in the interest rate environment should push those costs higher, returns from foreign currency assets would deteriorate to that extent, making it important to determine whether and how much to reduce such hedging activity. Adachi says that the company will consider specific approaches by the time of the next portfolio revision.