European crisis gives debt investors pause

The European sovereign debt crisis is causing institutional investors in Europe to rethink their exposures to eurozone government debt.

Investors are dumping traditional government bond benchmarks and fleeing to German, French and Dutch bonds, corporate bonds and emerging market sovereign debt. Still others are simply reducing all eurozone exposure in their bond portfolios.

“The dominant effect of the recent sovereign debt crisis is it is becoming less and less clear what a safe asset is,” said Michael Korn, Frankfurt-based managing director and head of institutional business development in Germany at Allianz Global Investors. “The perception of what credit risk is has changed drastically, and allocations are being adjusted accordingly.”

Paul Kenny, Dublin-based senior investment consultant at Mercer LLC, said: “We are seeing a lot of concern from clients. ... Clients are talking about moving portfolios away from aggregate bond portfolios to those focused only on AAA-rated sovereign debt.”

This is a strategic move rather than one that most Irish pension funds will look to do in the short term, he said, as transaction costs and losses from selling distressed assets in favor of soaring ones would be too high a hurdle. “That's going to be a blocker,” Mr. Kenny said.

Officials at the 2.76 trillion Norwegian kroner ($422 billion) Government Pension Fund-Global, Oslo, are watching closely the 289 billion kroner the fund has invested in stocks — and 55 billion kroner in bonds — in Greece, Spain, Portugal and Italy, spokeswoman Siv Meisingseth told Pensions & Investments earlier this month. In 2009, the fund dumped some 77 billion kroner in government debt from those four countries.

Dutch pension funds typically hold Greek and Italian inflation-linked sovereign debt in their liability-hedging portfolios. Some are selling Italian debt in favor of inflation-linked swaps backed by non-euro bonds as a way to “prevent further exposure to southern Europe,” said Jelle Beenen, Amstelveen-based partner and head of investment consulting in the Benelux region for Mercer. They are hanging onto the Greek bonds because prices have sunk, and a sale would lock in those losses, Mr. Beenen said.

Dutch pension funds have been particularly hurt by the sovereign debt crisis as a byproduct of the European marketwide flight to quality, which drove down yields on Dutch government bonds, said Dennis van Ek, Amstelveen-based principal at Mercer. Lower bond yields increased liability values, which has hindered Dutch pension funds' progress out of deficit status, Mr. van Ek said.

Meanwhile, German investors want to dump government bonds issued by the so-called peripheral nations of Greece, Spain, Portugal, Italy and Ireland for fear of possible ratings downgrades and defaults, experts say.

The problem, however, is that bonds issued by these countries constitute about 40% of eurozone sovereign debt indexes; the loss of the five highest-yielding countries' debt leaves investors looking for returns and diversification elsewhere, experts say.

For some European investors, emerging market sovereign debt is stepping in to fill both diversification and returns gaps.

“We're putting that forward to clients as a way to diversify their sovereign debt portfolios,” said Edouard Stucki, senior investment consultant at Towers Watson & Co. in Zurich. “Trusting government bonds are safe is a belief that will have to be amended.”

DB Advisors is also recommending clients look to emerging market sovereign debt as part of a strategic shift to diversify away from euro debt. “People shouldn't be afraid that the (high-quality sovereign debt) playing field is shrinking,” said Georg Schuh, chief investment officer at DB Advisors, Frankfurt. “There are so many new markets opening up — you just have to have courage.”

European money managers and pension fund officials consider developed-market sovereign debt to be riskier than that issued by emerging markets, according to a recent survey by Fitch Ratings.

Among the 70 respondents, 70% said governments in developed markets face the greatest refinancing challenge over the next 12 months, while just 3% said the same for emerging market governments.

Similarly, 74% expect credit conditions to deteriorate in the next year in developed markets, while 80% expect credit conditions in emerging markets to improve or stay the same. The survey was conducted in April, before a $1 trillion support package from the European Union and the International Monetary Fund was announced May 10.

Anne-Laure Frischlander, Paris-based managing director at BNY Mellon Asset Management International Ltd., said French pension funds — which are run by insurance companies — are bound by guidelines that require them to invest in local-currency government bonds, typically French ones. However, European Union-wide regulations expected in 2013 could pave the way for replacing some euro-based debt with that of emerging markets in portfolios of French pension funds.

“Emerging market debt is a big trend right now, especially that issued in local currency,” Ms. Frischlander said. “The fundamentals are quite good.”

Veronique Cherret, director and head of institutional business at Aviva Investors in Paris, said she is having “more interesting discussions” about emerging market debt with insurance clients, too. “They are thinking about having a more strategic allocation to emerging market debt, but it would be quite limited.”

Other investors are considering getting away from benchmark-based investing and moving into unconstrained approaches, managers said.

“In the past, investors just picked any (standard) benchmark ... because they saw sovereign debt as just interest-rate risk and not credit risk,” said Frank Witt, Frankfurt-based executive vice president and head of business development for Germany and Austria at PIMCO Europe Ltd.

He said German investors are replacing traditional benchmark-based mandates with gross domestic product-weighted ones, or with “absolute-return” ones, where the benchmark is an absolute figure over a cash rate, such as the London Interbank Offered Rate.

“By moving to an absolute return-type benchmark, you address the issue of sovereign credit risk and you try to get away from a place where, if the market goes down, your portfolio goes down,” Mr. Witt said. He could not provide asset flows into absolute-return strategies for Germany, but said, “We have definitely seen significant flows” into the strategies.

Rather than switching benchmarks, U.K. investors have “a greater interest in potentially limiting the influence of sovereign debt within global aggregate benchmarks by moving to (custom-made) fixed-weight composite benchmarks,” said Lloyd Raynor, senior consultant at Russell Investments Ltd., London. Russell is also recommending clients consider dividing their government bond portfolios equally between liability-hedging bonds, whose duration matches that of their liabilities, and global credit mandates.

The question of dumping peripheral government debt presents an asymmetric career risk for European pension fund and corporate finance officials, AGI's Mr. Korn said: “If he loses performance because he's switching to the most conservative asset credit-wise, nobody will blame him. But if he sticks to the risky assets in the European periphery and something goes wrong, he has to take all the blame.”

“Very few (corporate pension funds) are choosing to ride it out,” Mr. Korn said.

Some money managers say the outlook for the entire eurozone is bleak, even as most European states — even Germany — have announced austerity packages to reduce budget deficits. “If these countries go gung-ho to sort out their problems with austerity packages, they could kill growth,” warned David Scammell, head of European interest-rate strategy at Schroder Investment Management Ltd., London. “If they don't grow, they're just chasing their tails.”

Theo Zemek, global head of fixed income at AXA Investment Managers SA, Paris, said in an e-mail response to questions: “The problem for investors is that they cannot sit this out. About a third of the world's government bond markets are in disarray.”