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Spain: A flight to the known

Spanish pension funds have increased their domestic government bond holdings as economic confidence slowly returns. Gail Moss reports

Encouraging signs that Spain’s economy may be on the upturn have helped boost confidence in Spanish government bonds, a mainstay of pension fund portfolios.

The balance of trade went into surplus earlier this year, five years after it recorded huge deficits equal to 10% of GDP. And unemployment appears to have stabilised.

These early signs of recovery have led to bumper returns on fixed income allocations.

According to Spain’s Investment and Pension Fund Association (INVERCO), Spanish occupational pension funds achieved a return of 8.37% for the 12 months to end-June 2013. This contrasts sharply with an annualised return of 4.63% for the three years to that date, and 3.18% for the five-year period.

The Mercer PIPS Asset Allocation Sample of Spanish Employee Pension Funds shows an overall return of 8.8% for the 12 months to end-July, with fixed income returning 7.5% and equities 15.6%.

“Good results for the fixed income component are due to higher exposure to Spanish government bonds, which returned 16% over the period, well above the 7% from euro government bonds,” says Xavier Bellavista, principal at Mercer in Barcelona.

However, asset allocation for occupational pension fund portfolios has remained largely stable over the past year.

At end-June 2013, 34.2% of Spanish pension fund portfolios was invested in domestic public debt, according to INVERCO. This made up over half the 57.7% invested in domestic debt.  A further 6.2% was invested in international fixed income.

“Until mid-2012, Spanish government bonds exposure accounted for about 15% of portfolios in our sample,” says Bellavista. “At that point, Spanish bonds suffered high volatility due to uncertainty about peripheral countries, then managers reduced their exposure to 11% in late 2012.” Since then, bonds have bounced back, thanks to a belief that Spain is weathering the worst of the economic storm.

Furthermore, last July’s statements by Mario Draghi, president of the European Central Bank (ECB), which committed the European Central Bank (ECB) to buying bonds from peripheral countries and confirmed the sustainability of the euro, have led to increased confidence in those countries, says Bellavista.

“So local managers have once more increased their Spanish bond exposures because of their now greater stability, and the attractive yields,” he adds.

Alvaro Molina, investment consultant at Towers Watson, Madrid, describes the popularity of Spanish government bonds as a “flight to the known”.

He says: “We have seen a reduction in allocations to other assets, in favour of Spanish government bonds and regional debt. These assets are very well known by local managers who are confident that Spain is not going to fall back, so they are investing, attracted by a limited risk perception and by the high yields.”

“The risk premium on Spanish government debt was around 600bp this time last year, and is now around 250bp,” says Jon Aldecoa, consultant at Novaster. “There has been a real return of around 4-6%, plus an additional 3% boost from the valuation effect. This means Spanish sovereign debt is paying a better return than any corporate bonds.”

Ángel Martínez-Aldama, director-general of INVERCO, says Spanish pension funds have recognised the value of domestic debt: “Ten-year German bonds, for instance, give a yield of around 1.2%, which is then eaten away by inflation.”

And he agrees that Spanish bonds have now become slightly more expensive: “It’s partly due to increased confidence in the political situation. The spread will be reduced further when international financial problems are seen to be resolved.”

But Molina says that fixed income portfolios suffer from home bias.

“We have been very concerned about the increasing allocation to Spanish government debt, and we have advised most of our clients to limit their exposure,” he says. “We think that concentrated positions in Spanish government debt imply assuming unrewarded risks. Our advice is for pension funds to have more diversification in terms of risk premia.”

But he says managers are at least preparing ahead by reducing duration on international fixed-income portfolios, as they expect interest rates to continue rising.

“The crisis has shown that investing in long-term bonds could be more volatile than equities,” says Martínez-Aldama.     

Equities make up 17% of portfolios – a percentage that has changed little during the financial crisis, but which has still not recovered to its peak of 30% in 2007, according to INVERCO. And Martínez-Aldama says he does not see the current allocation going up in the short term.

“Unlike other regional markets, there has not been a shift towards equities in the past year, because Spanish government debt still offers high yields, and equity allocation is very limited in the investment policies of most Spanish pension funds,” says Molina.

“Furthermore, Spanish equities might not be as attractive as equities in other markets, because of the economic situation in Spain.”

Even so, equities have had some impact on the pension fund return, although more muted than for government debt.

“So far, 2013 has been characterised by a volatile equity market,” says Aitor Corral, manager in Aon Hewitt investment department, Madrid. “The Spanish stock market has seen bullish months like April, with a 6.3% increase (7.13% including capital and income return), and significant reverses like June, when stocks returned -6.7% (-6.45% including capital and income).” He points out that the EuroStoxx 50 has also been highly volatile, gaining 3.3% in April and diving 6% in June.

Most equity investments are foreign stocks – 10.4% of portfolios, compared with 7.4% for domestic stocks, according to INVERCO – and these holdings are chiefly European.

“The preference is for European stock markets because the Spanish stock market is small and unbalanced, thanks to the very high weight of financial institutions and Telefonica,” says Aldecoa.

Aldecoa says that most of the equity contribution was achieved in the second six months of 2012, with high European equity returns averaging around 13-14%.

But so far this year, markets have been flatter.

“The last quarter has not seen as good an equity performance as the previous three, mainly because of market reaction to the Fed’s recent comment about the hypothetical end of quantitative easing,” says Bellavista.

A further feature of Spanish pension fund portfolios is the 8% of assets invested in insurance policies. With these, pension funds pay a regular annual premium to the insurance company in order to get a guaranteed return. Currently, investors can expect a return of capital plus 2-3% per year from a 10-year policy.

However, alternatives do not feature to any great extent in pension fund portfolios.

This is something which Novaster is keen to change.

“We agree with the big institutional investors worldwide that the allocation to alternatives should be increased,” says Aldecoa. “Of course, this depends on the maturity of the scheme and its access – depending on its size – to efficient and not expensive investment vehicles. For mature schemes, we advise investment in infrastructure if they are able to allocate €5m or more to obtain good investment terms.”

Novaster also considers that there are still opportunities in the secondary markets of venture capital or other thematic or specialist funds while discounts have narrowed.

Meanwhile, Molina says that though the Spanish economy appears to be improving, there are still a lot of imbalances.

However, he believes any further reduction in Spanish government bond yields will act as a catalyst for diversification in pension fund portfolios.

“Fund managers will have to look for other sources of returns, diversifying within the fixed income portfolio,” he warns.

 

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