More challenges to come
If they haven’t already, many pension fund investment managers will shortly be considering how to position their funds to meet the challenges of the new year and it certainly looks as though the new year will produce just as many challenges as this year has. It does not look like an easy ride ahead.
But first let me go back to what I looked at in the last issue of IPE. I had some very interesting responses to my column last month when I wrote about what I had described as the world’s first 50-year inflation-linked bond. So first, an apology, the bond in question was actually the world’s first government issued 50-year inflation-linked bond. Apparently, there have been other 50-year inflation-linked bonds, albeit very limited and not issued by governments.
My second thought is, however, to admit that I am now even more depressed. When it was initially issued, I worried about a 50-year index linked bond offering a real yield of 1.1% pa but what can one say now that, as I write, demand has pushed the yield to 0.86% pa. That means that some investors (and they are mostly pension fund investors) have been happy to settle for a real rate of return of as little as 0.86% over each of the next 50 years. What does this tell us about such investors’ opinions of alternative investment opportunities?
Well, firstly, original investors must be pretty pleased with themselves. Anyone who invested in the bonds at issue could have sold them and locked in a capital gain of more than 10% (by being earned in less than two months it equates to over 60% pa). However the vast majority of buyers of the Index linked Gilt did so as long-term investors or simply passive index investors so I suspect very few have been able to benefit from such a huge notional gain.
However, the view from these dizzy heights looks mostly downhill and the only way I can applaud what is going on is from the point of view of a UK taxpayer. From this perspective I must encourage my government to issue as many bonds as possible, but please don’t let my pension fund buy them.
So, instead, let us look at the alternatives. I was interested to read recently that the big Dutch pension fund ABP has said it will raise its allocations to hedge funds from 2.5% to 3%. In addition ABP is said to have made very attractive returns this year from its investments in private equity and commodities. Indeed, there does appear to be a generally increased appetite for alternatives from pension funds throughout Europe as investors realise just how unattractive are the opportunities in equities and traditional bonds. I imagine this also explains much of the demand for index-linked stock, although why investors want to buy long-dated linkers I can not explain.
Certainly, Professor Jakob Brøchner Madsen from the University of Copenhagen’s Department of Economics has some interesting views on the subject. His concern is that
if the present largely US-led money expansion continues it will have severe inflationary consequences. The resultant inflation will then reduce real returns on assets. If, however, money expansion growth is arrested it will result in a credit crunch and a significant fall in asset prices. Professor Madsen’s advice is therefore for funds to buy inflation indexed bonds and switch back into equity only when stock prices have been reduced to half their current level.
I believe there are other alternatives and international real estate should certainly figure on the list of alternatives that pension funds should consider. When one realises that much prime real estate provides returns in excess of quality bonds but still offers the potential for long-term capital appreciation, I am amazed that many funds have not invested in the sector at all. Strangely, many real estate professionals seem rather subdued when talking about property’s prospects. Perhaps commentators have gotten used to the idea that property should yield more than bonds. If we are headed for inflationary times this yield gap would no doubt soon reverse, as it did in the past.
However, one of property’s attractions is its diversification benefits. Over the years, real estate has demonstrated very low return correlations with the more traditional asset classes, as obviously neither bonds or equities particularly benefit from higher inflation. Interestingly, property could also be attractive to pension funds at the moment as it should lower the return volatility. In future I believe pension funds will find low volatility a particularly useful attraction from its investments. With pension fund assets being ever more closely monitored by accountants and regulators, volatility is seen as quite a sin. Pension funds are hardly allowed to ignore the short term any more. In fact we seem to have all but forgotten that pension funds have in the past ridden out some pretty nasty stock market crashes and just seen them as short-term asset value fluctuations!