Spain: Crisis philosophy
Gail Moss finds that Spanish pension funds are confident about their ability to weather the storms of financial and economic turmoil
In early summer, the Spanish government started consultations with the pensions industry on plans allowing pension funds - if they wish - to value part of their sovereign debt portfolios at amortised book value, rather than mark to market. This is intended to reduce volatility for investments held to maturity.
But the government had already clarified existing rules to help pension funds deal with downgrades of sovereign debt.
Pension schemes may inform members of a change in investment policy brought about by changes in ratings in their quarterly report, rather than having to issue a specific note.
They also have up to 12 months to adapt their portfolios in line with investment policy changes following downgrades, so they can avoid selling assets at the wrong time.
In some quarters, the proposal on sovereign debt valuation has been taken as an attempt to encourage pension funds to buy an even greater volume of Spanish government bonds than they do already.
Yet even without this incentive, there is a growing demand from pension funds for the asset class.
"Occupational pension funds are increasing their allocations to fixed interest assets, especially Spanish assets," says Xavier Bellavista, principal at Mercer.
At end-June 2012, financial debt - both sovereign and corporate - held by Spanish pension funds made up nearly 60% of an average portfolio, according to figures from the Association of Collective Investment Schemes and Pension Funds (INVERCO).
In contrast, equities have dipped below 20% of portfolios, compared with 30% five years ago.
"Market performance for equities has not been positive in the past few years, while volatility is still too high - even in second pillar schemes, valuations are made daily," says Ángel Martínez-Aldama, director-general of INVERCO.
Over half the domestic fixed interest exposure (and 31% of pension fund portfolios overall) was Spanish government debt, up from 20% of portfolios three years ago.
Domestic private debt was around 25%, while overseas debt - both public and private - had reduced slightly, to 7% from 11%.
Until the late 1990s, Spanish pension fund portfolios were heavily biased towards domestic holdings.
But the first few years of the millennium saw a rapid diversification abroad, reducing Spanish exposure to its weighting in the European benchmark.
However, the financial crisis has prompted a homeward flight. Despite of Spain's own economic problems, both public and private paper is still seen as less risky than the alternatives, probably due to negative real returns in non-domestic sovereign bonds, according to Martinez-Aldama.
"Spanish pension funds are still buying debt of the weaker euro-zone countries, but they are also increasing the weighting of domestic public debt as against foreign debt," says Ricardo Pulido, investment practice leader at Aon Hewitt Spain. "Over the past two and a half years, the weighting of Spanish government bonds has increased by one-half, that is, over 10 percentage points."
Caser Seguros, which manages €4bn-worth of assets for 80 pension funds, buys only domestic debt, partly because, as a Spanish-based entity, it believes it possesses more information about the local economy than about others, according to Manuel Alvarez, the group's director, personal life and pensions. But Caser is not increasing its allocation to government debt.
"Although interest rates have rocketed, we do not consider it prudent to increase the risk," says Alvarez. "We are also avoiding government bonds with a duration of more than 10 years. To some extent, we are reducing maturities to reduce volatility, and the average duration of the portfolio is now three to five years."
However, it is important to distinguish between bonds issued by entities within the euro-zone, and by those outside.
Mercer's latest survey of Spanish pension fund portfolios shows that around 3% of fixed interest assets are held in non-euro-denominated currencies.
"This percentage is significant," says Bellavista. "It used to be zero, but non-euro paper is gaining in relevance because funds are now diversifying."
Reducing the average duration of fixed interest portfolios is also being seen across the board as an effective way to protect against risk.
"Our advice is to diversify, diversify, diversify," says Jon Aldecoa, consultant at Novaster. "However, the allocation to sovereign debt has always been high, and continues to be so even now. But new investments are being made with shorter time horizons - say three to five years - because of changes in interest rates."
Aldecoa says that very short-term (under a year's duration) notes or letras issued by the Spanish government are also popular, because of their high yield, over 5%: "Pension schemes are taking the opportunity of getting a high yield over a shorter period during the crisis."
And he agrees with the use of core euro-zone bonds as a security mechanism, but again, always within a short time horizon: "Interest rates are too low at present - they offer security, but at a very high price. We think in three or four years, pension funds could regret that choice."
But he says institutions are taking the crisis in their stride. "The feeling within Spain is less panicky than what is perceived abroad - in my opinion, the British and German press are over-reacting to the situation," he says. "In some cases, the current level of interest on sovereign Spanish bonds is quite attractive."
In particular, Novaster's view is that these interest rates might appeal to mature pension schemes, experiencing net outflows to beneficiaries because there are few active members.
"We are advising these clients that, taking risk into account, they can invest with high interest rates over the long term - say 10 years," says Aldecoa. "But we're recommending they increase the duration step by step, because of the changing situation."
He is also philosophical about the economic risks of sovereign debt. "In the long term, we don't think Spain will have to leave the euro, but if it happened, Spanish pension schemes would have to pay pensions in the new local currency," he says. "In that case, liabilities would also be in the new currency, so there would not be any mismatch. Leaving the euro would mean the risk of high inflation, but that's an economic risk, not a currency risk."
For institutional investors, the debt issue is complicated by the fact that bonds are also issued by regional governments.
However, Alvarez points out that risk levels vary, because some regional governments are huge borrowers, while others are not so highly leveraged.
In order to assess levels of risk, Caser uses credit ratings published by regional governments as well as its own research, analysing figures such as the level of expenditure of each region.
"Because liquidity is so important, we invest in short-term notes of no more than two years' duration, which can be attractive, depending on the spread over national government debt," says Alvarez.
While fixed interest investing continues to focus on domestic bonds, for equities, there has been a slight shift the other way.
Spanish pension funds have, over the past 18 months, been reducing domestic equities, in favour of euro-zone, US and emerging markets equities, according to Pulido.
"In general, we are advising them to diversify in terms of geographical location and also manager, so they are increasing holdings of mutual funds," he says.
"At Caser, we have increased allocations to the US and in general, non euro-zone shares over the past two years," says Alvarez. "We also have small holdings in emerging markets."
Alvarez says that even for domestic equities, risk can also be lowered by using a quasi-global approach.
Investments by Caser in Spanish listed equities are restricted to internationally diversified companies such as Telefonica and the fashion group Inditex.
Novaster is introducing clients to the concept of tapping global markets through diversified growth funds, though these are not much marketed in Spain.
"If the pension scheme is big enough to negotiate lower fees, then it can explore the concept of diversified growth funds not only in developed markets, but also new funds in emerging markets," says Aldecoa. "It's a means for them to take risk in a diversified way."
The Mercer survey also shows that while pension funds maintain a small allocation (1% of the portfolio) to real estate, holdings of alternatives are slowly increasing, and now make up 3% of portfolios.
However, the larger pension schemes invest up to 10% of their portfolios in the asset class, according to Aldecoa.
"Alternatives are expensive for the smaller schemes - fees are still high, perhaps a 1.5-1.75% management fee plus 15% of profits or carried interest," he says. "But for larger schemes, alternatives can be a way of diversifying. The diversified growth funds we're promoting include alternatives, and their volatility is lower."
But he says that a technical brake has now arisen for investors in alternatives.
"They tend to be risk-takers, so they invest more in equities as well," he says. "But because stock markets have fallen much more than the accounting value of alternative assets, these pension funds are now technically overweight in alternatives."
He notes: "Those that had 10% of their portfolios in alternatives now find the allocation has risen to 11 or 12%, so many of them are not investing further, even though they like the asset class. Those that are still investing are looking for discounts in the secondary markets."
Meanwhile, in early September, there was still no indication as to when any changes in the rules on sovereign debt valuation would be enacted by the government.
"There has been a mixed reaction to these plans from the industry," says Bellavista.
"And the new valuation method would be quite complicated for managers to implement."
He says that should the changes go through, reactions from occupational pension funds will depend on how active their trustees are.
"Hands-on trustees are likely to study the pros and cons of these measures in their plans, while trustees who are not so involved and prefer simply to review their managers' reports, will not," he says. "What they will continue to do, however, is diversify, especially via non-euro income investments and alternatives."
However, INVERCO does not favour the proposals. "There would be problems in switching because transfer values for workers moving in and out of schemes would not reflect the real value of their assets, and conflict of interest would arise," says Martinez-Aldama. "If sovereign debt were valued at amortised book value, members leaving a scheme would have notional capital gains which did not, in reality, exist. This also means that some members would end up subsidising others."