Asset Allocation: Autres temps, autres mœurs
France’s institutional investors, like most across Europe, are struggling to adapt to the low-interest environment. But Carlo Svaluto Moreolo finds that they also face a unique set of ‘heterogeneous’ problems
The unprecedented pressure on bond yields has left investors suffering across Europe, but for French pension providers the matter may be worse than elsewhere.
At a glance
- At aggregate level, French pension providers are heavily invested in high-rated fixed income.
- The French market, though ‘heterogeneous’, is tightly regulated.
- Investors are raising duration in fixed income portfolios.
- A search for diversification and alternative sources of yield has begun.
- French institutions are constrained when it comes to investing in riskier assets.
Many describe the French institutional investment sector as ‘heterogeneous’, referring to two facts. First, it is composed of several types of entities with different missions and objectives. Second, the degrees of expertise, capacity and regulatory control vary greatly across the sector.
Many observers believe that French investors are stuck between a rock and a hard place. Low bond yields are putting liabilities under pressure but, because of capacity and regulatory constraints, they are either unwilling, or unable, to diversify into riskier assets.
As a short-term result, they will either continue buying investment-grade fixed income paper to meet their solvency requirements, or maintain their fixed income portfolios unchanged, trying to reap the benefits of the ECB’s bond-buying programme.
Clearly, that is not ideal, as it increases systemic risk. Jean Médecin, member of the investment committee at Carmignac Gestion, says investors with an ALM focus are investing in a heavily pro-cyclical manner.
“There is a self-fulfilling mechanism, which is partly caused by regulation, whereby, as rates go down further, investors buy even more low-yielding securities to avoid asset-liability mismatches,” he says.
He adds: “Regulation is creating a disincentive to invest in risky assets.” This underlines an “inconsistency” between regulation and the wider European monetary control system. “Sovereign bonds are considered safe assets, but only so long as there is a lender of last resort,” Médecin says. “But, the ECB is prevented from acting as lender of last resort.”
Depending on their mandate, investors are looking for solutions. Médecin says regulated pension providers, including insurers, are simply raising the duration of their fixed income portfolios. “They are really pushing along the maturity curve,” he says.
Discussions with clients, adds Médecin, indeed revolve around investing in “riskier” assets, from equities to the outer fringes of the credit markets. “Some investors are trying to get exposure to credit, including structured products such as CLOs. We also see interest in transparent equity strategies based on high-dividend yielding stocks.”
Frédéric Cruzel, head of Lombard Odier Investment Managers in France, confirms that most investors, largely because of regulation, are “sitting and waiting.” He adds: “They are targeting flexible bond funds so they can give room to managers to manage duration and credit exposure.”
However, Cruzel points out many investors are looking at the convertible bond market. This asset class, he says, can be used to add portfolio diversification by investors constrained by regulation.
“We need to embrace risk, the good risk that comes at a reasonable price”
One pension fund that invested in convertible bonds early on is ERAFP, the €23bn second-pillar pension fund for public sector employees. The fund awarded a mandate to Lombard Odier in 2012. Chief executive Philippe Desfossés says: “ERAFP started to invest into convertible bonds to diversify its corporate bond allocation. At the end of 2012, corporate bond yields were already beginning to fall. With the exposure to convertible bonds, ERAFP sought to improve the performance of the corporate bond allocation by capturing a part of the increase of equity markets while limiting downside risk through the bond floor of the convertible bonds. As interest rates keep decreasing, convertibles tend to morph into stock with a put option.”
From this January, ERAFP – which is regulated independently – can benefit from rules that allow the fund to diversify further into asset classes including public and private equity and infrastructure. This will help the institution weather the low-rate environment better than other entities.
Desfossés says: “To adapt to the low-rate environment, we generally focus on diversification. We are looking for real estate investments and will increase our asset allocation in equities. We will use the flexibility provided by the new regulation specially to initiate investments in private equity or infrastructure.” As for ERAFP’s fixed income portfolio, Desfossés says the institution will focus on the US.
He agrees, however, that French investors may have to re-think their fixed income allocations to adapt to this environment, which looks set long term.
Will investors heed that call? If that is the case, one might wonder how serious the risk is of a massive exit from sovereign and corporate bonds that will create problems in the markets.
Just to give a sense of scale, the French institutional investment sector is worth more than €200bn, and commentators believe almost 75% of assets are invested in low-risk fixed income.
Jérôme Teiletche, head of cross-asset solutions at Geneva-based Unigestion, speaks of a “fundamental asymmetry” developing in the market. The reasoning is quite straightforward: if investors do not adjust their sovereign bond allocations, the level of risk will increase as yields are pushed down. Equally, if they sell sovereign bonds and “go down the rating curve”, they are bound to acquire securities that carry a natural liquidity risk.
Teiletche says multi-asset solutions represent an attractive alternative for investors. Investors shifting from traditional, mostly passive balanced mandates to more dynamic multi-asset mandates and factor investing, may find more diversified sources of return, as well as a focus on risk management, he says.
The debate is open. Frédéric Dodard, head of the Investment Solutions Group at State Street Global Advisors, believes that risk is low. “Absent a specific event such as Grexit, I do not see an exit danger. The central bank is going to continue buying bonds for a year and a half, and investors generally have to favour bonds because of regulatory issues.”
Still, most French investors are focused on the “status quo”, confirms Dodard. While some insurers have branched into high yield, some white-collar funds (caisses de retraite) are targeting US fixed income. “Investors,” says Dodard, “are going to keep whatever they have.”
Médecin stresses that regulation is exacerbating market dynamics to the point that a bubble may be developing and suggests that rules should be relaxed to restore their ability to take risks.
“Managing risk is a lot more than solving an equation to ensure the solvency of pension funds,” he says. “We need to embrace risk, the good risk that comes at a reasonable price.” The real risk for pension funds, he adds, is not being able to generate returns.
Desfossés believes lawmakers should help investors by making liability management more efficient. “Encouraging households to contribute to funded retirement schemes would be consistent with that goal. It would also generate patient capital that is much needed to finance long and illiquid infrastructure projects.”