Nordic pension funds have always displayed a bias towards domestically issued fixed income. In the current economic climate, dominated by historically low bond yields and liability-matching, the illiquidity and short maturities that characterise these markets are causing inefficencies in investment models. Nina RÖhrbein reports on the responses of regional players
Institutional investors in the Nordics have historically displayed home bias, especially in their fixed income portfolios.
A typical Nordic asset allocation consists of 50% or more in fixed income, 20-35% in equities and 10-15% in property and other alternative investments.
Investors with liability-matching focused strategies usually have a higher fixed income allocation, while allocations to equities or alternatives tend to be higher for investors with an asset-based strategy.
Denmark has, on average, a fixed income allocation of more than 70%, consisting of 58% local fixed income and 15% international fixed income. The average domestic fixed income allocation stands at 38% of the overall portfolio across the Nordics, according to Danish consultancy Kirstein Finans.
The majority of Danish fixed income portfolios are mortgage and sovereign bonds. Corporate bonds, like in the rest of the Nordics, tend to be international, as are credit, emerging markets and non-investment-grade fixed income.
“If they have a high longevity risk on the guarantees, Danish pension funds want a higher duration on their assets, which is easier to find in covered mortgage bonds than domestic government bonds,” says Sidsel Møller, senior analyst and head of advisory solutions at Sparinvest.
Swedish pension funds have less fixed income exposure than their Danish counterparts. This is because Danish funds have been subjected to market and risk-based solvency for some time, so are a step ahead with their liability-matching strategy.
A large allocation to domestic bonds offers a good hedge versus the liabilities, without the need for currency hedging. Management fees for domestic bonds are lower compared with global bonds, while the significantly better government debt situation in the Nordic region compared with the troubled US and the euro economies means that domestic bonds seem a less risky alternative.
In fact, Nordic bonds are generally considered safe havens. This explains why the home bias has remained stable in recent years, although global bonds now play a more significant part in the asset allocation today.
“The Danish fixed income market is fairly liquid, and also highly rated in terms of risk calculation, which makes it attractive to investors,” says Jan Willers, head of department financial market research at Kirstein Finans.
The disadvantage of such a home bias is that the domestic market is smaller and more concentrated, with less diversification and fewer return opportunities compared with the global market. Nordic corporate bonds in particular are not very liquid, which is why Nordic investors mainly approach the corporate bond market through European or US products.
With interest rates dropping sharply, the performance of domestic bonds has been strong, making them an important contributor to the overall portfolio performance in the recent volatile equity environment.
But their future performance looks problematic. “Interest rates are very low and will rise again eventually, which means domestic bonds will not be able to generate good returns for pension funds,” says Møller. “In other words, they could be more sensitive to interest rate increases than decreases, which traditionally was the major concern.”
Although, Møller says that due to the ongoing crisis a lot of the larger mortgage institutions in Denmark expect interest rates to drop even further over the next two years, with bond yields at historically low levels and regulators restricting the short-term risk, one of the main challenges for Nordic institutions will be how to achieve their long-term return targets of typically 4.5-6%.
“If Danish pension funds have guarantees of 4.5%, which many of them still do, they need positive returns from some other asset classes. They cannot expect sufficient returns from their domestic bond portfolios alone,” says Møller.
With long bond yields at slightly below 2% for Sweden’s 10-year government bonds, the expected return on other assets has to be high to achieve the overall return target. Large equity allocations will be costly in terms of risk and investors will have to find other sources of long term return for them to meet their objectives.
“More pension funds are looking at setting up the infrastructure to use swaps, derivatives and other overlays,” says Andreas Larsson, consultant at Wassum Investment Consulting in Sweden. “By using those they can more freely move around their allocation within fixed income - in other words, they could choose emerging market debt and still have the liability matching in their portfolios.”
But Nordic pension funds have also started to search for different fixed-income investments to generate stronger returns and increase diversification in their portfolios. “After the credit crunch, many investors took the opportunity, and allocated to global corporate bonds,” says Larsson. “With corporate credit spreads back to more normal levels, attention shifted towards emerging market debt. The relatively strong economic outlook for many of the emerging market economies together with the high bond yields has attracted investors. Focus has also been on shortening the duration and reducing interest rate risk in the fixed income portfolio.”
But the local fixed-income market continues to dominate in Nordic pension funds’ portfolios and has been stable for the past three years at least. “However, with the advent of derivatives, which allows them to hedge the liabilities the need for local fixed income might not be as pronounced as it has been before. But it is a slow development and we have to yet to see the impact on their asset allocation,” says Willers.
Another factor that can lead to possible changes in fixed income portfolios is the imminent arrival of Solvency II.
Its impact will depend on the pension funds’ current regulations, solvency situation and practice of market valuation of the liabilities (see articles on Solvency II in this section).
“In Denmark, pension funds have been focused on solvency requirements and liability-matching strategies for a long time and the implementation of Solvency II will probably have less of an impact than in other Nordic countries,” says Larsson. “However, in Sweden, some of the less regulated pension funds, the Pensionsstiftelser, are not affected by Solvency II. For these corporate DB plans, the big issue is the upcoming accounting standard changes of IAS 19.”
“Norway has come, by far, the shortest in having an asset liability match, which Solvency II is all about,” says Helge Arnesen, Nordic CIO at Alfred Berg.
Although it is yet unclear how Solvency II will be implemented in the regulations for the insurance business, it is set to lead to stricter and more volatile capital requirements. And capital requirements for domestic bonds will, of course, be lower than for other fixed income products.
“Nordic bonds are investment grade and higher, which is why they will have the lowest possible capital requirement in the Solvency II calculations,” says Willers. “Therefore, while we see investors looking for some of the riskier products, they will continue to invest in domestic bonds. Institutions will have to make up their minds whether they will take the risk in fixed income or in equities under Solvency II.”
Solvency II is also likely to cause a shift from unrated to more A-AAA rated securities, due to the increased scrutiny on the solvency levels of the issuer. “More pension funds will opt for rated issuers - of which there are fewer in the region - and supplement those with only a handful of unrated securities,” says Arnesen. “Investors also need to have much more duration than what is available traditionally and diversification will become even more important.”
But Arnesen says it is impossible for Nordic pension funds to properly prepare themselves for the new regulation due to the lack of synchronisation between the existing rules and Solvency II rules. Until there is harmonisation between legacy pension rules, the incoming Solvency II rules, QIS capital adequacy type rules and accountancy rules, investors cannot take the required steps because all these regulations point to different optimal solutions.
“Investors are still sitting on the fence trying to find out which way to jump,” Arnesen says. “Defined contribution seems to be the only available solution going forward. In Denmark, we are seeing this shift to DC already taking shape.”
Some Danish pension funds have received the go-ahead from the financial authorities to change their guarantee into a declaration of intent. New hybrid products that only offer a money-back guarantee have also surfaced.
“Many Danish pension funds are trying to move their members to non-guaranteed, unit-linked or life cycle schemes,” says Willers. “This development started before the advent of the new regulation due to the struggle of Danish pension funds trying to meet their 4.5% guarantees, but Solvency II is accelerating this development.”