Switzerland: The hunt for yield
Emma Cusworth charts the search for a yield pick-up
In parallel to the massive decrease in interest rates and the corresponding increase in liabilities, Swiss pension funds have been engaged in a hunt for yield. Pension funds, struggling to meet liabilities and restore funding levels, are caught between the need for higher returns and concerns over future inflation.
At the same time, attempts to diversify are stifled by domestic bond market concentration while exchange rate fluctuations dampen appetite for international bonds.
In August, yields on ten-year Swiss Confederation bonds hit a record low of 1.03%. While they climbed to 1.37% by 30 September 2010, rates will likely stay low, further pressurising funding ratios. Between September 2008 and March 2009 the Swiss National Bank (SNB) reduced the three-month LIBOR rate from 2.75% to 0.25%.
"As rates fell in recent years, pension schemes have relaxed fixed income investment guidelines, supported by the change in the BVG guidelines effective from January 2009," says Juerg Bretscher, Swiss bond portfolio manager at Vontobel, "We have seen investment in corporates increase and a gradual tendency to move up the duration curve and down credit ratings."
The SNB forecasts that interest rates will remain low for 2011 at least. In mid-September, it held rates and cut its inflation target. The annual increase in consumer prices may not exceed their 2% ceiling before the second quarter of 2013.
Some experts believe deflation is more probable given the robust franc and cheap prices abroad.
According to Martin Oetiker, senior vice president at Banque Syz: "Inflation is almost absent in Switzerland. Due to the stronger franc and the possibility to detax the VAT on exported goods, consumers are tempted to buy products in neighbouring countries. We are therefore in a more deflationary environment, but this could change in 2012 together with a probable recovery of the euro."
Global growth rates in 2010 and 2011 are expected to underperform 2009 levels, supporting current interest rate policy in Switzerland. Uncertainty over inflation has left many schemes underweight long-duration bonds versus their dominant benchmark, the SBI, further pressurising returns.
Sven Ebeling, Mercer's head of investment consulting in Switzerland, says: "Being short duration might have been a cautious strategy but yields at the short end of the curve are extremely low. Consequently, pension funds can ill afford to hold such assets. It leads to deteriorating funding levels. In addition, such a position did, and most likely will continue to, underperform any traditional bond benchmark.
"Those currently running short duration portfolios probably won't have the courage to increase duration risk again," he adds. "Uncertainty about what is going to happen at the long end is simply huge."
Overall, however, duration has increased. Since 2008 the foreign and domestic 10 year-plus buckets in the SBI increased 0.9 and 0.6 years respectively, while the index weight fell 0.68% and 0.11%. Even this slight shift suggests increased demand given the conveyor belt of maturity.
Patrick Bucher, deputy chief investment officer at Credit Suisse, says: "The low rate levels surprised many investors. Funds' actual positioning guarantees a certain level of demand for duration, even at current levels, in order to limit the gap to benchmarks and/or liabilities. We therefore expect rates to normalise at higher levels than today but there will not be a dramatic shift."
Even if they wanted to, concentration means the Swiss bond market lacks the necessary liquidity for schemes to respond quickly. If rates rise sooner than expected, many will be caught out. The small number of issuing companies already necessitates schemes benchmarking against the broad SBI index, which tracks over 1,000 AAA to BBB rated issuances.
"The market dries up very quickly," Ebeling says. "As soon as you go outside the government bond segment the remaining universe of liquid bonds is pretty small. This is particularly true for longer maturities, say above 12 years, or for lower credit bonds."
Liquidity is further restricted by pension funds' usual buy-and-hold approach and a potential decrease in new issuance across the board. Because Switzerland has not had to bail out banks, and has experienced strong economic performance and consistent GDP growth, growth is expected to be around 3% in 2010 and 2% in 2011, so a flood of new government bonds is unlikely. Public debt was an estimated 41.3% in 2008 according to the federal finance administration.
Despite regular funding needs, over the last two years the average weight of government bonds in the SBI has dropped from 24% at the end of 2008 to 17.1%.
According to Bucher: "Switzerland has long lived well with this problem, so pension funds and other institutions are used to diversifying in other high-grade segments of the domestic bond markets." Foreign bonds, Swiss franc denominated issuances from international companies, have increased around 3% since December 2008.
"The stability of the currency and economic environment have attracted international issuers," Bretscher says. "In January 2009, the 30% regulatory limit for pension funds' exposure to this segment was removed. While pension funds have not rushed into this space, we have seen higher issuance frequency and demand is also up."
Swiss franc denominated bonds are increasingly less attractive to international issuers, however, as the interest rate differential with other European countries is fast disappearing.
Even domestic corporate issuance could stall after a brief surge during the crisis as financial institutions tightened lending and the SNB supported corporate bonds to maintain liquidity.
"The financial crisis did see some increase in the number of issuances as more small and mid-cap companies turned to the bond markets to refinance debt as bank loans dried up," says Stefan Meyer, Analyst with UBS Wealth Management Research. "If this trend continued it would be good for the market."
However, Bretscher questions the life-expectancy of increased issuance: "While panic in the haze of the financial crisis led to some issuance from small and mid-caps needing to refinance bank loans, it has not been a fundamental change." Ultimately, concentration remains the death-knell of increased liquidity due to the small number of companies able to issue bonds.
For broader liquidity, schemes are forced into international bond markets. Figures from Complementa, however, show that the average allocation to international bonds fell nearly 2% since 2007 to 10.51% by the end of 2009.
This diminishing trend is hardly surprising given the collapse in the US dollar and euro relative to the Swiss franc.
Foreign exchange fluctuations played no small part in the relative underperformance of international bonds: Domestic bonds returned 4.17% for Swiss pension funds between January and the end of September 2010 versus 1.6% for international bonds according to the UBS Pensionskassen Barometer.
According to Stefan Angele, head of investment management at Swiss & Global: "Demand for bonds is up as funding levels are under pressure. The maths of what schemes have to produce to meet liabilities means funding will deteriorate further given current extremely low interest rates. As a result their ability to hold risky assets is quite low, which forces them to adopt more conservative strategies pushing them into bonds and real estate, which are considered to be low risk by the regulator.
"This is the traditional way of looking at things, but it is dangerous," he warns. "With yields on three year bonds at 0.7% and 10 years at 1.5%, how do schemes expect to recover funding levels?"