The great bond shortage?
IPE asked three pension funds in three countries – the Netherlands, the UK and Switzerland: ‘Does the scarcity of high-quality long-term government bonds highlighted by the OECD, pose a problem?’ Here are their answers:
Peter Scales, chief executive of the London Pensions Fund Authority, which has AUM of £3.2bn (€4.7bn).
“There does appear to be a scarcity of bonds, or at least there is an increase in demand for bonds, which seems to have been building up for at least the last five years – since FRS 17 came in.
“There is a move from equities into bonds, led initially by insurance companies protecting their positions (often for regulatory reasons), but also by pension funds to get actuarial valuations that are more closely matched to the way their liabilities are moving.
“That’s something that we did back in 1992.
“The price is extraordinarily high so I’m not sure that I would want to switch from equities to bonds at the moment, but lots of people are doing it and saying that it’s what pension funds should be doing.
“People are trying to match out with bonds to get an actuarial valuation that reduces their levy on the PPF. You get a different actuarial valuation if you are holding bonds as opposed to holding equities based on future assumptions, and that seems to be driving the markets much more than the normal investment strategy approaches.
“Looking back, there was a period when the government reduced its borrowing demands and may be reluctant to issue a lot more bonds at a time when more people want them. But we are entering a time when governments will need to start issuing more bonds, although in a controlled way.
“I’m not sure they will issue more 50 years as the take up was disappointing previously because of the pricing, so they have got to get the pricing right. It’s more likely they’ll issue in the 20-50 year period because that’s the gap into which more pension funds are moving in an attempt to match liabilities at the longer end because people are living longer.
“Recent indications suggest that in the 15-20 year period there’s a big enough market for bonds not to cause prices to rise, but it’s the long end that actuaries use to value the liabilities which is causing these pension deficits.
“And that’s the big problem that LPFA has at the moment. Over the last six months we’ve changed the strategy we introduced in 1992 when we tried to match our liabilities to linked gilts on a fairly passive basis, and we have moved to what we call cash-flow matching bond mandates.
“So we are selling not buying bonds at high prices and we put the money with managers who are using swaps to match our cash flows. We set mandates where we want our future cash flows given back to us plus 1.5% on average to meet deficits. And we are using other instruments to get the cash flows that we want in the long term rather than just sitting on gilts and seeing what happens to their yields. We use a variety of other assets – private equity, property, private finance initiatives and possibly commodities but we’re not there yet.
“We don’t know whether that is going to be the final answer for us but it is certainly helping us match out the longer term.”
Paul van Gent, fund manager at PME, the Dutch industry-wide Metalektro fund, which has AUM of €19bn.
“Scarcity is a difficult concept for financial markets as they always price supply and demand. Additional demand for interest rate risk matching could have consequences for the price but hopefully then issuers will find the long end more interesting as investors bid up the price and down the yield for long bonds so stabilising yields. If this stabilising mechanism is slow to react then price movements can be large.
“So while the scarcity question is an issue, I don’t think one should worry about it too much.
“For a pension fund, not dealing with interest rate risk is an active investment decision and one would assume that such a decision would be taken with an expected return in mind for running that risk.
“In the end they will be judged on whether they were right or wrong. In the interim they should be judged on whether they took an acceptable risk.
“And while risk management can play a role, I don’t agree with the Bank of England’s suggestion that people are buying index-linked government bonds ‘regardless of price’ because I don’t think that people can buy anything regardless of price and keep their job for any amount of time.
“While regulations may seem to force people to do things at the wrong time, usually they address an issue where the industry has not picked up the ball sufficiently.
“Anyone our size or smaller, say €20bn or less, should have had no problems purchasing whatever bonds or swaps they may have wanted over the last couple of years. That’s partially because not everybody did it and so allowed others to, but anyone saying they couldn’t do so because the market situation hadn’t allowed them to is not telling the truth. Rather they probably had the idea that interests were going up and were a punter in that area.
Perhaps the first question one needs to address is what there will be a demand for, that is whether it is for government bonds. As a pension fund we want to manage the interest rate risk. Government bonds would be suitable for this but we don’t necessarily want the return they give. Swaps are perhaps a more suitable instrument for interest rate management than government bonds.
“Someone has to want to pay long interest rates but whether that’s a government, a corporation or a mortgage payer is irrelevant as long as the investor can manage the credit risk. That said, governments are currently the major natural payer of long-maturity bonds.
“Going forward, governments may realise that everyone benefits from a stable economic structure and from stable pension funds because a large part of consumption will be coming from pensioners as the population ages.
“So as it’s in everyone’s interest that pensions remain and are well protected, I think that governments can step up to the plate and provide more long-dated bonds. In addition to seeing some political sense in this, treasuries may find the long end cheap or see opportunities to spread issuance over longer maturities to reduce their funding risk profile.
“In addition, companies may start coming into the longer end, because if like in the UK you have an inverse yield curve, companies wanting to finance long-term investment should be quite happy to use long-dated financing.”
Daniel Gloor, head of asset management at BVK, the Civil Service Insurance Fund Canton of Zürich, which has AUM of CHF19.5bn (€12.6bn).
“There has been a reduced issuance from the Swiss public sector last year and this and looking ahead into the short term because the cantons received a considerable proportion of the proceeds of a sale of gold reserves by the national bank last summer.
“So the outlook for the capital balances are quite bleak over the medium term. They still need to raise capital on the bond market but they need to issue less for the time being. This will mean that there are fewer capital or public bonds on the market. And usually they do issue long-term bonds, especially with the current low interest rates.
“But the federal government still has its agenda to issue capitals on a regular basis.
“However, this does not have a major impact on us. Like the rest of the Swiss pension fund sector, we are focusing on bonds with medium-term maturities because we still expect that interest rates will rise.
“We have adopted a rather cautious stance towards bonds. We were wrong regarding the interest rate outlook for the past two or three years – like the majority we were too pessimistic.
“We can diversify into euro bonds, dollar bonds or sterling bonds, but here again we are concentrating on medium-term bonds, say between five and seven years.
“We don’t have a system like in the UK or the US where long-term bonds are used for asset liability matching. We still try to keep to a broad diversification with regard to our asset allocation. Every year we evaluated our allocation against what could be the possible target return on overall assets. And this consists of Swiss franc bonds and foreign bonds but a considerable part is in equities and real estate.
“According to empirical data, usually we need an overall return of between 4% and 5% to cover our expenses.
“At the end of last year fixed income accounted for 55% of our portfolio, and the bond portion includes not only government bonds but also credit issued by quality names. We have some long-term bonds but compared with the benchmark for each capital market our investment strategy for the past three or sour years has been to be duration short. This is generally the current Swiss investment concept.”