European pension funds are plunging into European and U.S. corporate bonds in an attempt to boost yields in the face of low-yielding government bonds.
Dutch heavyweight pension funds PGGM and ABP -- as well as Brussels, Belgium-based Voorzorgsjas voor Geneesheren, Tandartsen en Apothekers -- and IBM are poised to increase their exposure to U.S. and European corporate debt and are busy revising their asset allocations.
Rates touch historical low
The move to increase yields comes at a time when European interest rates have touched their lowest levels in recent history. As a result, Belgian, Dutch and Swiss funds are increasingly concerned about how they will in future meet statutory return requirements of around 4% per year. Legislation and local actuarial guidelines in these countries require pension funds and insurance companies to provide annual returns at or above a specified level.
But Swiss utility pension fund Pensionskasse Schweizerischer Elektrizitatswerke, Zurich, is moving against the herd.
PKE portfolio manager Franz Winkler is concerned equity markets are ripe for a correction and dismisses as "too risky" other funds' attempts to enhance yields.
"Everyone screams for yield enhancement, but this is the wrong time. The question is to look at risk," he said.
Mr. Winkler is a voice in the wilderness, according to money managers and consultants who have seen a recent surge in inquiries about yield enhancement and corporate bond strategies from European pension funds.
Historically, European companies have relied on banks for debt financing. It's only during the past eight months that issuance of corporate bonds has taken off in a big way. Europe's corporate bond market is estimated to be worth $600 billion but it is still relatively illiquid compared with the U.S. market and tends to be dominated by issues from financial services companies.
Recent interest in yield enhancement is only slowly translating to increased fund flows into corporate debt. This market remains virgin territory for all but Europe's largest funds.
Dutch health-care workers' pension fund PGGM, Zeist, for example, is looking for external managers since it was given board approval to increase its exposure to international corporate bonds, said Niels Kortleve, co-head of investment strategy.
"We are looking for yield enhancement; that is why we want to broaden the scope of the portfolio" to include greater exposure to corporate bonds, he said.
The E45 billion ($47.2 billion) fund recently increased its exposure to European government bonds although its core investment remains in Dutch and German treasury securities. The E13.5 billion fixed-income portfolio is split 60/40 between government bonds and investment-grade credits that include corporate bonds and private placements with ratings above BBB.
Once the fund broadens the fixed-income portfolio to include U.S., Canadian and Japanese securities, it will explore the possibility of investing in below-investment-grade paper and emerging markets.
The fund is still deciding which of the international corporate or government debt portfolios will be managed externally, but Mr. Kortleve's preference is for international corporate bonds to be managed by a specialist money manager.
Fellow Dutch fund ABP also has increased its exposure to corporate bonds in order to optimize its portfolio. It recently appointed Pacific Investment Management Co., Newport Beach, Calif., and Western Asset Management, Pasadena, Calif., to manage two U.S. corporate bond portfolios believed to be worth around $200 million each.
The 320 billion guilder ($150.4 billion) fund has allocated 180 billion guilders to fixed income, with 70% of the portfolio in European fixed income and 30% in U.S. fixed income, respectively, said Paul Spijkers president of ABP Investments U.S. Inc., New York.
The European portfolio is internally managed and has not yet managed to meet its target allocation for corporate bonds because of the illiquidity of the European market.
The Belgian VKG pension fund has completely revised its strategic asset allocation and is splitting its E134 million fixed-income portfolio into two mandates, one a government bond portfolio and the other covering corporate debt.
The pension fund for doctors, dentists and pharmacists already has drawn up a short list of six managers for the two E67 million portfolios that will be divided between U.S. dollar, sterling and euro issues, said Karel Stroobants, VKG's deputy general manager.
The fund's bond portfolio is solely managed by Bank Dewaay NV, Brussels, which is in the running for a new mandate, he said. The fund will award that mandates in late October, with a startup date of January.
The fund is dividing the portfolio in order to diversify risk and adopt a more specialized approach to fixed income.
"We will give more attention to the bond portfolio over the next few years. The theory is that we will be in a low interest-rate environment for the next five years. But the volatility . . . could be high and I do not believe we can go on for much longer with the double-digit returns we have seen for the past seven years," Mr. Stroobants said.
Some form of yield enhancement, even by one percentage point, will be important to guarantee annual returns of 4.75% on the reserves despite the E453 million fund being overfunded by around 30%, he added.
London-based IBM Europe, Middle East and Africa also plans to increase its 10 pension funds' exposure to European corporate debt and at the end of this year will reduce its 15 external fixed-income managers to just five, said Martin Jack, IBM EMEA director of retirement funds.
Although the European corporate bond market remains a "little small," the company plans to widen its credit rating limit to include investments rated AA and lower and will award mandates to money managers able to manage both government and corporate debt, Mr. Jack said. The assets of the 10 pension funds assets total L20 billion ($32 billion), of which L8 billion is invested in European government bonds.
Using short puts
While some funds are eager to beef up their yields, Swiss pension fund PKE's portfolio manager Franz Winkler has taken a contrarian approach.
His tactics are to protect the 5.6 billion Swiss franc ($3.64 billion) fund from a correction in equity markets by using short puts on certain key equities to limit risk in the belief that technology, pharmaceutical and financial stocks are "tremendously" overvalued. Premiums from selling the puts give the fund some yield enhancement while protecting it from downside risks.
Mr. Winkler is so concerned about the risks of a market correction that, for the first time since 1991, between 9% and 10% of the 1.8 billion Swiss franc bond portfolio is now held in cash. The balance of the portfolio is invested in U.K. gilts, German bunds and U.S. Treasury bills. The fund has no exposure to corporate bonds because Mr. Winkler is concerned the securities are "not as liquid as they should be."
As the fund is overfunded by 125%, he said, and "capital preservation is our goal not yield enhancement."