Veritas – When will pensions exit debt, and is credit their next yield-port?

For European bond investors interested in capital gains, recent years have been great. For those targeting yield, including institutional ‘forced buyers’, it has been horrible.

The main question for price-focused buyers is, “when will the party end, how can I exit without being badly hurt, and where do I go then?”

One allocator suggested 0.75% yield on 10-year Treasuries – now at 1.62% – was one point at which investors may decide the price-party is over. When yields on 10-year Treasuries hit 1.45% in June, it marked a 220-year low.

At some point the days of near-rate free borrowing by governments in Berlin, den Haag, London, and Washington will end, and power will shift back from borrowers to lenders.

Morten Spenner, chief executive of fund of hedge funds International Asset Management, uses Germany as an example similar to other core, developed nations: “At some point there has to come a tipping point, a running out of patience. Investors will not want (Bunds at low yield) and there is then a tremendous change in dynamics. But pension funds are asking, what they should do, to meet their goals?”

The answer is definitely not to buy assets for 10 years yielding 1.4% per annum.

Elizabeth Corley, CEO of Germany’s Allianz Global Investors, says: “Should pension funds continue the trend of the last 10 years to invest ever greater proportions of their portfolios in government bonds – many of which are now offering low-to-negative real returns – they will find it increasingly difficult to meet their long-term liabilities. It is critical that the slew of regulations affecting the industry does not inadvertently prevent pension funds from making decisions that are in the best interests of their members.”

Those who sold 10-year Bunds when yields hit 3.4% in April 2011 did not act in the short-term interests of their clients, as yields since fell to 1.4%.

But few doubt that, over the longer term, current yields make little investment sense.

For a period, as yields fall and ‘normalise’, the power-play between government borrowers and their institutional lenders will likely be in some disarray.Even if yields revert to, say 3% or 4%, that will still lose money in real terms if inflation jumps as sharply as many expect. The partial vacuum left as price-based sellers exit might, therefore, not immediately be filled by yield hunters.

One answer in the meantime, for those hunting yield, might be to move down the spectrum, to credit.

But International Asset Management’s Spenner cautions that so much money has flowed into that asset class recently “some corporates now are not giving you enough yield, either”.

Research from Bank of America Merrill Lynch research from June supports his view. Fixed income funds received $540bn inflows since the start of 2009, and in 2010 took in more new business than they had between 2003 and 2008. This helped push yields to lows since 1958, the bank said.

Spenner adds standards on some bond prospectuses and covenants have slipped as demand exceeded supply. “Some investors are so focused on buying yield for their portfolios, they ignore this.”

International Asset Management has had ‘specialist credit’ as one of three primary themes driving its investment thinking recently. It launched a single-client credit mandate over summer.

Spenner says this year has been a difficult time for credit long/short. “They have been trying to pick up price action, and have had to contend with negative carry.” Most managers are flat or slightly down.

With prices and yields of core debt and credit at current levels, a pure long-only strategy seems somewhat questionable. Absolute return fixed income managers may soon have to deploy their shorting instruments to full extent. Long/short credit managers will have more flexibility.

Professor Gordon Clark from University of Oxford, said: “The imperative for alpha means that pensions funds, both large and small, are looking at increasingly innovative investment strategies and even relatively small pension funds are embracing alternatives.”


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