Earlier this year, the Swedish central bank decided to push repo rates into negative territory. Carlo Svaluto Moreolo explores how the country’s pension funds have adapted their portfolios
Earlier this year, the Swedish central bank decided to push repo rates into negative territory and begin quantitative easing. Some commentators see this as an alarming sign, speculating that some policymakers believed a full economic recovery in the country was further away than previously thought. But for Swedish pension funds, the most worrying development was neither a potentially slower recovery nor the actual cost of holding deposits.
At a glance
- As of March, the Riksbank’s repo rates edged to -0.25%.
- The Swedish central bank has also launched a €3bn ‘mini-QE’ programme to support inflation.
- As a result, Swedish pension funds are expanding their real asset portfolios, particularly real estate and infrastructure.
- A slow, unpredictable process of restructuring of fixed income portfolios has begun.
The problem is, undoubtedly, that funds have to somehow adapt to an environment where liabilities increase and returns from matching assets come under significant pressure. In February, the Riksbank announced it would cut repo rates to -0.1%. Later in March, the repo rate was further decreased to -0.25%. The authority explained in a statement that “there are signs inflation has bottomed out and is beginning to rise, but the recent appreciation of the krona risks breaking this trend”.
The bank also announced a programme to buy government bonds worth SEK30bn (€3bn), “to support the upturn in inflation”. The Riksbank said it would buy paper with maturities of up to 25 years until early May 2015.
The immediate reaction to the first negative rate announcement was a moderate sell-off of five, 10 and 30-year bonds. However, from a peak in early March, Swedish government bond yields are back on a downward trend. The government borrows for 30 years at around 0.86%, and 10-year issues yield less than 0.4%.
This continued flattening of the yield curve, which causes liabilities to increase and funding – though generally robust in Sweden – to suffer, leaves investors with little choice but to continue with their diversification programmes and bolster their real asset portfolios.
Per Frennberg, deputy CIO and head of asset management at Alecta, Sweden’s largest occupational pension provider with SEK680bn in assets, says the short-term movements of the repo rate are “not a big deal” for the company.
What matters, he says, is the abnormally low level of long rates. “For a long time, Sweden was ‘blessed’ with a relatively hawkish monetary policy, with significantly higher real rates than in the rest of the world.” That may have come to an end. If that is the case, Frennberg says the company’s balance sheet, its premium policy in the defined benefit plan, and the returns of the bulk of its fixed income assets will be negatively affected. “If so, it means tougher times ahead for a long-term net investor such as Alecta,” he adds. His hope is that “the current unique situation with negative rates will hopefully not last for long”.
Folksam, the SEK350bn provider of pensions and life insurance and 60% owner of local government pension scheme KPA, reported in its full-year results in March that its funding ratio had fallen to 155% in 2014, from 161% the previous year. The return in 2014 was 12%, up from 7.6% in 2013, thanks to the strong performance of its equity and fixed income portfolio.
“We could see a drift to a situation where we are more focused on guarding our solvency ratio rather than in looking for returns from yield pick up. We have no intention to seek more risky assets to keep up the expected return”
And though returns, particularly from fixed income, may be significantly lower this year, Michael Kjeller, CIO at Folksam, says the asset allocation has not changed since the end of 2014. The company holds around 40% in equities, 50% in fixed income and 10% in alternatives, consisting mostly of real estate.
Kjeller says: “We will be in a falling interest rate environment for a long time. The decision to set negative rates for deposits with the central bank was, indeed, historic. But it did not really change the environment we were already in.”
Kjeller believes the decision, though unprecedented, is “not dramatic” per se, but he acknowledges that the low interest rate environment has already prompted the fund to review parts of its asset allocation.
However, Kjeller adds: “We could see a drift to a situation where we are more focused on guarding our solvency ratio rather than in looking for returns from yield pick up. We have no intention to seek more risky assets to keep up the expected return.”
Instead, Kjeller says Folksam is doing what he believes everyone else is doing – planning to increase investment in real estate. In particular, the company is looking to increase real estate investment by SEK10bn over the next five years.
Folksam also hit the news this March when it was announced that a consortium of investors, in which the company owns a 17.5% stake, acquired Fortum Distribution, the second largest player in the electricity distribution market in Sweden. The transaction, valued at SEK60.6bn, gives the consortium access to 900,000 customers. The other investors include KPA Pension, Swedish buffer funds AP1 and AP3 and Borealis Infrastructure, an investor in public infrastructure owned by OMERS, the pension fund for local government employees in Ontario, Canada.
In an effort to prevent pressure on returns, the Sparinstitutens Pensionskassa (SPK), the SEK24bn pension fund for banking employees, overhauled its asset allocation last year, shifting away from a traditional 70/30 allocation to fixed income and equities, respectively.
Peter Hansson, chief executive at SPK, says: “Before the portfolio reallocation last year, we had a lot of exposure to long-term bonds. So when the market starts moving, we would be hurt. We wanted a portfolio that can perform well when interest rates go up – 25 years of falling interest rates cannot continue for much longer.”
As part of the asset allocation shift, SPK allocated 4% to infrastructure and 4% to real estate. It also invested 8% in alternative risk premia and 10% in hedge funds. The allocation to equities and fixed income is 30% and 50%, respectively.
Hansson believes the Swedish pensions system is “quite solid” and equipped to meet the challenges that lie ahead. The regulator requires funds to meet a funding ratio of 104%, and Hansson points out that the vast majority of funds meets this criteria.
However, he says: “I see a lot of major players are still invested in long-term bonds, and they clearly need to do something about that over time, or that is going to be a poison pill.”
The chief executive adds that the regulatory environment is adding further pressure, with many Swedish pension funds uncertain as to whether they will be regulated by IORP II or Solvency II. “The uncertainty in regulation may spill over to investment,” he explains, as investors consider how new rules will affect their ability to diversify.
Mats Langensjö, head of the Nordic region at Lombard Odier Investment Managers, says the overall situation poses “an extreme challenge” to Swedish pension funds. He believes that, because the Swedish system is based on return guarantees, some organisations will have to rethink their pension promises. “You are going to face lots of structural changes,” he adds, possibly including consolidation.
Langensjö believes that, while pension funds increase their real estate holdings to partly replace their fixed income portfolios, they also should be more proactive in the search for alpha-generating strategies in bonds and equities.
He says: “The availability of transparent, liquid buy-and-maintain strategies is scarce,” he says. “There are no free lunches. Investors should think carefully about what to do. If they want to improve their market exposure, they may have to do lots of small things, rather than implementing a few big changes.”
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