Pension funds seek the right risk-return balance in a low-interest-rate environment. Opportunities seem few and far between
• Swiss pension funds are facing the challenge of near-zero returns from Swiss franc bonds.
• They are moving towards lower-rated and riskier bond issuers, such as emerging market governments.
• Pension funds are exploring assets such as insurance-linked securities and infrastructure.
• Foreign real estate is an option as domestic property values have been pushed up by investment demand.
Swiss pension funds are facing a new paradigm in fixed income investing – the challenge of almost zero or negative returns in Swiss franc bonds, their historical core holding.
“That part of the portfolio is challenged to deliver yield and protect capital,” says Theodore Economou, CIO of multi-asset, Lombard Odier Investment Managers (LOIM) and former CIO of CERN Pension Fund. “But Swiss 10-year government bonds today are yielding 30bps, and bonds cannot be expected to protect capital unless they are held to maturity.”
Economou points out that Swiss bonds traditionally provide liquidity, but this is fractured.
He says: “So pension funds are having to investigate changes in asset allocation. And what we’ve seen is a widening of the guidelines for fixed income, in terms of the location of issuers and also moving to lower ratings, with more active management rather than using indices.”
One source of yield is emerging market debt. Although investors can buy debt in US dollars, LOIM favours local currency: “You can achieve yields of around 6.5%, whereas in US dollars it would be more like 2.5%,” says Economou. “That is still attractive relative to zero, but we believe local currency debt provides a better yield and is more diversified.”
“Pension funds are going below investment grade, also into corporate bonds,” agrees Franz Wenzel, institutional solution strategist at AXA Investment Managers. “They are also looking for longer duration bonds – up to 20 years’ duration to help close their funding gaps.”
Another way to boost returns and diversify are allocations to foreign real estate. Currently, the average allocation to property is 20%, but there is less than one percent in global property, according to Dominique Grandchamp, head of investments, Aon Switzerland.
“Forward-looking yield on Swiss real estate has gone down, because valuations have risen,” says Grandchamp. “There has been strong demand from both local and foreign investors because of the bond-like cash flows in rental income, the quality of assets and the country’s stability.”
Noticeable shifts are occurring in alternatives. “Pension funds have moved more into riskier assets as a response to declining yields,” continues Wenzel. “When they’ve filled their risk budget with traditional asset classes they expand into alternatives such as insurance-linked securities, because these are less correlated investments.”
Economou says: “Swiss pension funds have had exposure to traditional alternatives – private equity, hedge funds and commodities, for 10-15 years, but now there is interest in new alternatives, particularly catastrophe bonds and infrastructure. With cat bonds, we’ve seen recent events push up premia by 200bps.”
He has seen funds using multi-asset alternatives as additional building blocks. “These are traditional underlying investments which are managed dynamically to deliver simultaneously risk control and an attractive return in a very liquid format,” Economou says.
Michael Valentine, investment consultant at Willis Towers Watson, says: “Swiss pension schemes are significantly exposed to the traditional asset classes, where the expected return for unit of risk has deteriorated significantly. In particular, directly or indirectly the equity risk premium represents a very heavy concentration of risk in most portfolios.”
He continues: “We think there is lots of value to be added by diversifying into alternative asset classes, and are encouraging clients to consider new sources of return, where governance budgets allow.
As ever, there is the dilemma of whether or not to hedge foreign currency holdings. Hedging into Swiss francs is expensive, but reducing the hedge increases foreign currency risk. Grandchamp says: “Most clients hedge bonds 100%, but most don’t hedge equities. Some hedge up to 50% equities in order to minimise regret risk.”
Grandchamp says a few clients have implemented active currency overlay strategies for some portions of their portfolios denominated in foreign currency.
Valentine says: “Hedging costs are a major factor for the Swiss franc investor and make them think twice before investing more heavily abroad.”
He continues: “Nevertheless, there is still considerable scope for diversifying assets outside Switzerland, for example into emerging markets, and also foreign property, given the price levels of domestic real estate. Tactically, at the moment we have a slight preference for the euro-zone over the US.”
Grandchamp concludes: “Little is being done to manage the exposure to duration and interest rate risk. Risk management remains an area where there is room for improvement by Swiss pension funds.”