Yield hunting in risky assets is dangerous
In an article published by the FT (below), there are really interesting comments and projections affecting institutional investment decisions. These decisions are the basis for private investment (in my opinion) and the recommendations from some of the experts quoted below really point to diversity, security and less risk exposure. Hardly surprising we thought of forestry immediately. If you haven’t already thought of Forestry investment, then please check www.fact.ie or the document attached. Article with thanks to Chris Flood from the FT
A quarter of the bonds issued by governments and companies worldwide are currently trading at negative yields — which means that $14tn of outstanding debt is being paid for by creditors in a bizarre reversal of normal practice.
Negative yields have forced long-term institutional investors, such as pension schemes and insurance companies, to make unprecedented changes to their asset allocation mix because sovereign bonds can no longer deliver the returns needed to meet the promises made to retirement savers.
Negative bond yields are a direct result of the vast asset purchase schemes introduced by central banks to stave off a worldwide economic slump after the financial crisis.
Quantitative easing programmes were intended as emergency measures that would be withdrawn once it was clear that a sustainable economic recovery had begun.
But with the trade war between the US and China slowly suffocating global economic growth, central banks have embarked on a fresh round of liquidity measures to try to prevent a recession.
© (FT) The Federal Reserve cut US interest rates on Wednesday for the first time in more than a decade, a change that the European Central Bank is expected to follow next month.
Speculation is also building that the ECB will restart its bond-buying programme before the end of the year to try to stimulate economic growth in a moribund eurozone.
As a result, the challenges presented by negative bond yields are set to intensify.
Torsten Slok, chief US economist at Deutsche Bank, says interest rate cuts by the Fed and moves to ease monetary conditions in Europe, China and Japan will drive pension funds and insurance companies to hunt for better yields in riskier assets.
This could be a dangerous course of action, he warns.
Many pension funds and insurance companies increased their holdings of corporate credit, equities and structured products, as well as alternatives including private equity and real estate, after the 2007-08 financial crisis.
Mr Slok fears that some of these investors have been lulled into a false sense of security as reductions in US Treasury yields over the past decade were accompanied by strong gains for equities and a tightening in the spread (gap) between yields on corporate bonds and government debt.
“This correlation only worked because the US economy did not fall into a recession. But if interest rates are going down because there is likely to be a sharp slowdown in global economic activity or even a recession, then it does not make sense for pension funds to buy more risky assets,” he says.
Torsten Slok warns against the false sense of security some pension funds and insurers have fallen into previously The Fed’s monetary policy shift has led to an inversion in the US yield curve (where short-term interest rates are lower than long-term rates), a historical warning sign that the economy could move into recession.
“The Fed will have to quickly resort to unconventional monetary policy, notably QE, if the economic outlook turns sour,” says Silvia Dall’Angelo, senior economist at Hermes, the London investment manager.
Worries that a recession is looming are widely shared by investors. A poll of more than 400 clients conducted by Barclays in June found that half thought a global recession would start before the end of next year. The other half did not expect it until 2021 or later.
Rick Rieder, global chief investment officer of fixed income at BlackRock, says that although a US recession over the next couple of years is possible, the Fed could respond by cutting interest rates to zero and reigniting QE.
Mr Rieder says it is “difficult to see a change” in the established trend for pension funds and insurance companies to take on more credit risk and to increase their exposures to alternatives, given the shift by the Fed, ECB and central bankers in emerging markets to relax monetary policy to support economic growth.
QE programmes and a decade of ultra-low interest rates have inflated stock markets worldwide. The S&P 500, the main US equity benchmark, hit an all-time high in late July, up 347 per cent from its post-crisis nadir in March 2009.
Strong gains for stock markets over the past decade have helped many US pension schemes to narrow the funding gaps between assets and liabilities.
Mr Rieder says many US pension funds would like to buy more bonds to extinguish their liability stream but this has become difficult because of low interest rates.
“Pension funds can’t match their liabilities with where rates are today so they have to hope that equity markets will continue to rally,” he says.
At the same time, US companies are deleveraging, which has shrunk the supply of new corporate debt, leading to a dearth of investment-grade issuance. Net supply from municipal borrowers, another vital source of new issuance, has also turned negative so there is not enough available for pension funds and insurers to buy.
© (FT) US 10-year Treasury yields have dropped from 3.24 per cent in early November 2018 to 1.88 per cent following the Fed’s rate cut.
These reductions in US interest rates will increase the funding gaps faced by many US public pension plans.
Greg Tell, head of fixed income specialists at JPMorgan Asset Management, says pension schemes can counter these problems by increasing their holdings in high quality, long-duration bonds that tend to do well when interest rates fall and growth slows.
Such bonds include US Treasury STRIPs, investment-grade bonds issued by non-cyclical companies, along with high-quality credits including commercial mortgage-backed securities issued by government-supported agencies such as Freddie Mac and Fannie Mae.
Life insurance companies with long-dated liabilities can pick similar high-quality bonds that tend to do well in an economic slowdown along with short-dated securitised consumer credit as the US consumer sector has benefited significantly from low interest rates, says Mr Tell.
The Bank of England could also be forced to cut interest rates to support the UK economy in the event of a no-deal Brexit.
Steve Turner, a partner at Mercer, the investment consultant, says declines in 10-year gilt yields, which have fallen from 1.7 per cent in late September 2018 to just 0.55 per cent, have led to a deterioration in the funding position of pension schemes, depending on their level of liability hedging.
He warns that corporate pension schemes that do not already have robust hedges (protection plans) against unexpected changes in interest rates and inflation should consider increasing gilt holdings before yields possibly fall further. A fresh drop would create bigger deficit problems at a time when cash flows at their parent companies are under pressure because of the slowdown in the global economy and the uncertainty over Brexit.
“I am encouraging defined benefit corporate pension clients that do not have high hedge ratios — at least 80 per cent of their funded liabilities — to maximise the level of hedging that they can afford to do before yields fall further. Trustees should think about protecting funding positions as many parent companies are already trying to minimise how much they pay into their pension schemes, preferring to invest in technology, research and development to strengthen their businesses,” he says.
Bonds account for more than half (54 per cent on average) of the assets held by UK pension schemes, according to Mercer’s 2019 European asset allocation survey. Hedging ratios vary widely by scheme but just over half of the 876 European pension plans surveyed by Mercer have hedging ratios of 80 per cent or more in place this year.
Jos Vermeulen, head of solution design at Insight Investment, says most UK DB pension schemes are well funded, unlike five years ago. Increases in hedge ratios should also offset any further downwards shifts in interest rates.
“Movements in interest rates have less of an impact now on the funding position of DB funds in the UK,” says Mr Vermeulen.
Central banks look determined to prolong QE’s sugar rush to financial markets but that can only mean that the $14tn headache caused by negative rates for pension funds and insurance companies will remain unresolved for the foreseeable future.