The A$9.2 billion (US$9.7 billion) Melbourne-based VicSuper has adopted a customized index for its passive bond investments, dropping its market-cap-weighted index in favor of one with less exposure to the U.S. and Japan.
Market veterans expect a growing number of Asian institutional investors to take similar steps to better diversify their sovereign bond allocations.
The defined contribution superannuation plan adopted a benchmark designed with the fund's investment partners, capping holdings of any single country's sovereign bonds at 10% of VicSuper's overall sovereign bond allocation.
That upper limit represents a sharp cutback for countries such as the U.S. and Japan, which account for 30% each of the sovereign bond allocations in market-cap-weighted indexes such as the Barclays Capital Global Aggregate benchmark previously used by VicSuper.
The switch to the custom benchmark was prompted, in part, by concerns about “the considerable concentration risk” of the Barclays Global Aggregate's roughly 60% allocation to sovereign bonds, Ronan Walsh, portfolio manager-fixed income with VicSuper, said in an e-mail.
VicSuper's new approach will go a long way toward addressing the investment team's concerns about the “concentration and default risks in the government bond market” now, Mr. Walsh said in a telephone interview.
The era of market-cap-weighted bond indexes that changed gradually enough to let investors sleep soundly at night ended in 2007, noted Peter N. Horn, executive director and head of J.P. Morgan Asset Management's Australia business, whose headquarters is in Melbourne.
Aggressive bond issuance since then by governments in the U.S., Japan and Europe has caused rapid changes in those indexes and their risk parameters, effectively forcing investors to evaluate which of those changes they're happy with and which entail unwanted risks, he said.
With yields near historic lows and the accumulated indebtedness increasing among developed countries, traditional bond markets “have never been riskier,” and a lot of mental energy is going into figuring out how to continue having “sovereign global exposure without the excessive concentration,” said Andrew Canobi, a vice president, fixed-income portfolio management, with Deutsche Asset Management in Melbourne.
How to adjust passive allocations to account for those greater risks is a “red-hot conversation now,” said Mr. Horn, who called moves such as VicSuper's the “tip of the iceberg” in terms of changes being made by institutional investors.
Still, there is far more talk than action.
Alternatives to market cap-weighted bond indexes — designed to avoid the pitfall of having to make ever-greater allocations to countries falling further and further in debt — have yet to gain traction in the region, investment consultants say.
Such alternative “smart beta” benchmarks include the GDP-weighted Global Advantage Bond index launched by Pacific Investment Management Co. in 2009 and the RAFI sovereign bond index launched by Research Affiliates LLC in 2012, which uses a combination of GDP, population, landmass and energy consumption to determine a country's sovereign bond weighting.