By Baptiste Aboulian
©Alexandre Buisse
Pension funds will be forced to buy chunks of the trillions of US, UK and EU long-dated sovereign bonds to be issued over the next few years – but with disastrous consequences, experts say.
Solvency II-type regulations and financial repression – in which governments are pressing institutional investors to buy debt – will push pension funds to invest in government bonds. The problem, however, is that government bonds offer low-to-negative real returns that will eat into pension funds and increase those funds’ growing deficits.
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While financial repression can help governments to shrink debt, this type of policy is definitely not favourable to pension funds, says Jerome Booth, head of research at Ashmore.
“Financial repression works well, as it did after the second world war, but it is distortionary,” he says. “Whilst it’s good for the taxpayer, as a saver I think it’s outrageous. Anyone who invests money in sovereign bonds has got some explaining to do.”
Recent monetary policy in developed markets has already pushed down government bond yields, but experts say the situation could get worse. One concern is that over the long term, a period of high inflation or strong currency moves would lead to a great reversal of government bond prices.
Mr Booth adds: “In markets, risk is always moving. It’s not acceptable to shove people’s money into deposits or government bonds.”
Countries such as Denmark have introduced changes to reduce pension funds’ need to buy debt to match their obligations. Sweden recently changed the way liabilities are calculated. But elsewhere pension funds are piling on government debt.
Stewart Cowley, head of fixed income and macro at Old Mutual Asset Managers, says this is a mistake because the asset class will not match future liabilities: “And yet at the same time, government bonds are being pushed out and force pension funds to buy the wrong thing.
“What we are doing is transferring government risk inside pension funds. I don’t think it is to the advantage of the end user,” he says.
A “tsunami of government bonds” is expected to be issued globally in the next few years. In the US alone, $5tn of new bond issuance could take place by 2017, Schroders, the FTSE 100 fund manager, forecasts.
Government bonds currently have two major risks attached, says Mouhammed Choukeir, chief investment officer at Kleinwort Benson: “The first is that a flood of money into the market is leading to inflation and therefore a rise in interest rates to compensate.
“The second is the credibility of sovereigns to pay. With huge debt burdens and budget deficits as far as the eye can see, it is difficult to see how [governments] are going to plug that hole.”
Others, however, are less convinced that government debt is inappropriate for pension funds. Charles Cowling, managing director of JLT Pension Capital Strategies, says: “You have to start from the presumption that if you are a pension scheme delivering a guaranteed promise, then the most sensible investment is the one closest to matching the liability that you’ve got. This is sovereign bonds.”
The risk of default for major borrowers – such as the UK, France or Germany – is “negligible or minimal”, Mr Cowling adds.
It may not make sense to speak of a “risk-free rate” for sovereign bonds any more, but that is the closest investors will get to safe assets. Meanwhile, investors in sovereign bonds may get negative real returns, but there are not many alternatives. Investors can take more risk – and many do, investing in corporate bonds and high-yield paper – but Mr Cowling says the natural place for a pension fund to start is to match assets to liabilities.
“Government bonds still make sense for a lot of schemes. But with interest rates so low and not all inflation hedged-out, deficits are large,” he says.
Could inflation pick up strongly in the months ahead, making matters worse? Simon Foster, managing director at UBS Global Asset Management, says that despite the explosion of central banks’ balance sheet, “inflation does not seem likely in the next 12 months and default is not a question at the moment”.
Jérôme Broustra, head of fixed income global rates at Axa Investment Managers, adds: “The time when you get out of a recession with a 5 per cent interest rate is over. If growth makes a strong return [there could be an issue with sovereign bond prices], but that is not our scenario.”
Financial Times
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