On the Record: Sovereign bond risk?
Beware of abrupt changes
We own government bonds, but they are mostly very liquid, very safe assets, including German, French and Swedish bonds, as well as triple-A-rated Danish mortgages. We do not own any Italian bonds, so we were not affected by the recent jitters. At the moment, we are thinking about how to build some inflation hedging into our portfolio, because a large rise in inflation could move the markets.
In the near future, we will start a discussion about what our duration exposure should be over the coming years. At the moment, our strategic asset allocation calculations tell us we should have neutral duration exposure in the long run. If we believe we will be in a rising-rate environment over the coming years, it will be prudent to take positions that somewhat underweight duration.
In general, I believe there will there be an important issue going forward, when the European Central Bank (ECB) ends quantitative easing (QE). My experience is that it is very difficult to smooth these transitions. Often sell-offs come quite abruptly, because that is the way market psychology works. If the ECB just steps away and signals that rates are starting to rise, and underlying inflation starts to rise, I think the market will sell off relatively fast and in quite a substantial manner, in a way that will be difficult to control. Maybe the conclusion is that the ECB cannot end QE completely. It could become a much more ordinary instrument.
However, the question is, when do you act on all this? It is very difficult to predict when the sell-off will start. If you were to trade against the market, by shorting the long-duration bonds, you would face a material negative carry on your position.
Journey towards diversification
Our portfolio has become much more diversified since 2011. The last significant changes to the strategic asset allocation were made in 2015. At the time, we broadened the portfolio to emerging market equities and raised the share of corporate bonds. We also allocated to hard currency emerging market debt. This meant divesting from European government bonds. From this perspective, we are less worried about moves in the sovereign debt markets than if we still had a high share of the portfolio invested in those markets.
Our allocation to Italian government bonds is around 13% at the moment. Sometimes, market falls such as the one we witnessed in May, represent opportunities to buy undervalued bonds. That was the case in 2011, when we bought Italian assets following the downgrade from rating agencies. It proved to be a good decision.
We agree with Mr Draghi that a euro breakup is unlikely, but we do hope that the ECB’s exit from the markets will be as orderly as possible. The rules are not clear yet. Obviously we do not look forward to more market wobbles like the recent ones, and our managers are positioned defensively. We have added international managers to our roster as a defensive move.
The big question, at the moment, is whether Italy’s public debt is sustainable. Hopefully the government picked up the markets’ message.
Focusing on alternatives
We are risk-averse when it comes to sovereign fixed-income exposure. We have invested in German covered bonds, known as Pfandbriefe, and agencies, which we carry on our own balance sheet, as many German institutional investors do. In general, we avoid ‘periphery risk’ as much as possible, investing mainly in Germany or core countries of the euro-zone.
We also allocate to illiquid asset classes, including real estate and alternative investments. Those long-term investments are mostly not exposed to the market moves we saw in May. We allocate around 20-25% of our assets each to real estate and to alternatives, which includes private equity, infrastructure equity and private debt.
Thanks to this approach, we were largely unaffected by the euro-zone sovereign crisis of 2011-12. We did hold senior unsecured German bank loans but we had no impairments on those investments, and we now avoid such investments.
We do not have any investments in investment-grade corporate bonds at the moment. However, we do invest in high-yield bonds and loans. There is a fraction of periphery risk embedded in the European part of the high-yield portfolios. However, I do not think we will see a significant rise in bond yields over the next one to two years. The macroeconomic outlook for the euro-zone is currently worsening, but the ECB will not increase rates until summer/autumn of next year.
Interviews by Carlo Svaluto Moreolo