The next batch of investment disappointments could come from currency bets made in domestic bond portfolios, pension investment consultants are warning.
Many domestic bond portfolio managers have invested 10% to 30% of their assets in international bonds, and, as a result, are making currency bets. Such bets can be tricky.
For a few portfolios the situation may be like "a nuclear power plant ready to blow," said James Kaplan, president of Capital Management Sciences Inc., Los Angeles, a provider of analytical software and an investment consulting firm. Mr. Kaplan foresaw that derivatives would be a problem for some portfolios months before problems occurred.
International bonds are frequently being used in portfolios to "goose up yields," said Mr. Kaplan. But some portfolio managers have no adequate reading on the risks they are taking because of some outdated calculation methods.
Many institutional domestic bond managers "have really been aggressive in trying to increase the octane in their portfolios by doing derivative or international strategies," said Stephen Nesbitt, a senior vice president at Wilshire Associates, Santa Monica, Calif.
Although the exact dollar amount is unknown, managers of U.S. domestic bond accounts are thought to be putting billions of dollars in international bonds to remain strong amid fierce competition.
A Pensions & Investments survey found investment in actively managed international bonds rose 307% to $55 billion as of Dec. 31, 1994, from $13.5 billion as of Dec. 31, 1987.
A significant portion of that amount is believed to be in domestic bond accounts.
Morningstar Inc., Chicago, is now compiling information on mixed domestic bond and international bond portfolios for mutual funds. Although responses are just starting to come back, more than 80 mutual funds reported percentages in foreign bonds from a range of 10% to 56% of holdings.
Now, consultants say, currency bets the managers have been taking could start to go against them if an anticipated secular strengthening in the U.S. dollar against the yen and European currencies is in place.
Since the dollar hit a low in spring 1995, the dollar's value is up more than 20% against the yen and 10% against European currencies.
"My own personal view is that the dollar has embarked on a multiyear uptrend, and foreign currencies have embarked on a multiyear downtrend, which is a reversal of what we have seen in the last 10 years," said Michael Perelstein, managing director of the global department at the money management firm MacKay-Shields, New York.
The difficulty for domestic bond managers is that at potentially crucial turning points there is seldom unanimous agreement on where currency exchange rates or interest rates are headed, so managers can dump the about-to-be troublesome securities or hedge the currencies fully.
"It would be difficult to get a consensus out there that the dollar will strengthen on a longer-term view right now," said William Kohli, managing director at Putnam Investments, Boston.
A second danger for some of the managers, said Mr. Kaplan, is lack of understanding or tools to adequately measure the currency risk they are taking - just as many of them didn't understand derivative risks they took.
"In this international market, people had better be aware that this currency risk is substantial and highly volatile," said Mr. Kaplan.
One bond operation that already has felt the sting of a currency going south is Fidelity Investments, Boston. At the end of 1994, some Fidelity bond investments suffered not only from derivative problems but also from the collapse of the Mexican peso.
And it isn't just investments in emerging markets debt that can be troublesome. "There is clearly significant opportunity even in non-emerging market currencies to take a big hit if you are in the wrong place at the wrong time," said Oren Cheyette, manager of fixed income research at BARRA Inc., Berkeley, Calif., an investment consulting firm and analytical software provider.
Wilshire's Mr. Nesbitt said managers "often sell (to plans sponsors) such a move as a way to diversify overall risk. But what has actually happened is that the new segments are generally in higher-risk investments that often have or can hurt performance."
MacKay-Shields' Mr. Perelstein said: "Clearly, one of the reasons people went toward international bonds historically was to capture the currency gain."
He said some investors are going to have to "re-learn" the reason for investing in the bonds, which are good for diversification.
Consultants are warning pension fund investors about the dangers of international currency movements. But they warned them about potential dangers in derivatives, too.
Of course, domestic equity managers buying international stocks face currency risks, too. But many of them have been investing in international assets a little longer than domestic bond managers.
Also, points out Mr. Nesbitt, "Bond managers seem to be pushing the envelope. It is probably the bond portfolios where the greatest surprises have been found over the last couple of years - surprises in terms of derivatives, surprises in terms of securities lending and surprises in terms of foreign bond holdings.
One reason the competition is so fierce among bond managers is that they are trying to show they are adding value but have fewer areas from which to choose.
"One of the big issues is alpha and how much value added can you put into a portfolio," said Mr. Kohli.
Equity portfolios contain many beta factors where value can be added, but domestic bond portfolios have much fewer factors and the range between a top manager and a bottom manager in any given year is probably 20 to 60 basis points, said Mr. Kohli.
The universe of securities used in domestic bond portfolios has been less defined. Bond portfolios managers "will reach out to high-yield corporate bonds, or they will reach out to emerging markets that gives them a little extra kick," said Mr. Kohli.
"If you are limiting yourself to duration and sector it is very difficult to compete with someone who is maybe grabbing a little bit of emerging market exposure or a little bit of international bond exposure," said Mr. Kohli.
Mr. Kohli doesn't understand why the use of some securities hasn't been more of an issue with clients.
Mr. Cheyette said: "A couple of years ago, (domestic bond managers) might have looked to the collateralized mortgage obligation market to get enhanced yields. Having been burned there, many managers are looking to put 10% overlays of global bonds."
He said the "risks in owning global bonds are comparable to owning some of the more volatile CMO tranches. So understanding the risk characteristics of the portfolios is quite important in those cases."
Putnam portfolio managers are very aware of currency risks, said Mr. Kohli. Putnam has some domestic bond portfolios with international bond holdings that are fully hedged and take no currency risk. Other domestic bond portfolios are unhedged and actively manage currency risk.
In the non-hedged holdings, said Mr. Kohli, clients understand the volatility of currencies and are measuring the performance on a longer-term basis.
"We see valued added through an unhedged benchmark effectively, so we are willing to accept some of the short-term fluctuations for longer-term strategic purposes."
There is a "big difference" in non-institutional mutual fund management style and institutional accounts, said Mr. Kohli. "I would be surprised if institutional managers didn't have a good handle on how much risk they were taking through the currency markets in a domestic mandate."
Consultants also say some international bond investors don't want to hedge because of losing upside potential; even when investors hedge, they must do so in the right way to protect themselves.