Core sovereign bonds, already at historically low yields, are becoming more volatile, pushing some institutional investors to seek additional cover.
At one extreme, some pension funds in Europe are opting to hold cash, rather than buying more government bonds. Previously a respite from turmoil in equity markets, cash is now being used as a potential "safe haven' from "safe-haven' investments, according to pension funds, managers and consultants.
Even when bond investors haven't gone as far as adding cash, many are reducing the overall duration of core fixed-income portfolios. Globally, they're accelerating efforts to diversify into a broader array of investments at the lower end of the credit spectrum to obtain more yield without taking on more interest-rate risk, sources said.
“This is the most challenging area (for investors) right now — how to find stable returns within their fixed-income portfolios” amid the potential for higher interest rates, widening credit spreads and higher inflation, said Nick Spencer, director of consulting for Europe, the Middle East and Africa at Russell Investments, London.
In the U.S., the daily volatility of 30-year Treasury bonds in 2012 was about five basis points per day, corresponding to a daily price movement of about 1%, according to data compiled by iShares, the exchanged-traded funds unit of BlackRock Inc. In comparison, the daily volatility of the Standard & Poor's 500 index was about 0.81% during the same period.
German bunds had their worst one-month return in 10 years during January, when prices dropped by more than 1.5%, only to bounce back strongly in March as the Cyprus bailout threw a curve ball into the eurozone crisis. Over the past year, the 30-day volatility of 10-year German bunds has outstrippedthe equivalent in the Euro Stoxx 50 index.
U.S. Treasuries, German bunds and U.K. gilts have played “a big part in providing (investors with) a safe haven” in the past five years, said Stephen Cohen, managing director and head of investment strategy for Europe, Middle East and Africa at iShares, London. “Recently, investors are becoming more aware of the risk within these investments that are often deemed risk-free.”
The risk/return profile of investing in certain core government bonds has become “very asymmetric, whereby investors are left with limited upside and a lot more to lose if interest rates rise,” said Anders Svennesen, associate director at the 624 billion Danish kroner ($107 billion) ATP, Hilleroed, Denmark. Mr. Svennesen is responsible for investment allocation across risk categories at the fund.
Portfolio managers at RPMI Ltd., London, increased their allocations to cash in the past year as equities have been “sold into strength” while concerns about significant tail risks remained, said Keith Shepherd, chief investment officer. RPMI manages about £18 billion ($27 billion) on behalf of more than 100 pension plans within the U.K.'s railway industry.
RPMI's defensive fund was launched about six months ago to pool assets from various pension plans in a relatively conservative inflation-matching strategy. More than 20% of that fund's assets are in cash.
The defensive fund is one of two multiasset pooled funds that together compose more than half of RPMI's total assets. The other fund is RPMI's pooled growth strategy, which is aggressively return-seeking but also has been adding to its cash position. Cash now accounts for between 10% and 15% of the portfolio.
“A high cash weighting for capital preservation in the bond market is a good thing. If liabilities fall and we have cash, we will have outperformed,” Mr. Shepherd said.
Others are revising “the universe that they consider to be risk-free,” said Jozsef Szabo, head of global macro at Aberdeen Asset Management Inc., London. “One of the biggest themes is the blurring of the lines between developed and emerging markets” within core fixed-income portfolios.
The Barclays Capital Global Aggregate Bond Index returned -2.31% in the past three months in U.S.-dollar terms on an unhedged basis, with a yield of about 1.74%.
“There have been periods of volatility, but this time, it's at the same time that yields are very low,” iShares' Mr. Cohen said.
In such an environment, some investors “don't want to buy bonds at these yields, so parking in cash at the moment can make sense,” Mr. Cohen said. However, he and others warned that if yields continue at such low levels or drop further, investors with a narrow cash strategyinstead of core government bond holdings could still be worse off in real terms.
“Cash is not a riskless asset within the context of (pension) liabilities, but what it does do is to provide principal protection,” Mr. Shepherd said. Like other investors globally, RPMI has broadened its fixed-income portfolio to help protect against a rise in interest rates. About 3% of the total invested in an alternative fixed-income portfolio that includes emerging markets debt, commodities, global investment-grade credit, reinsurance and agriculture. Furthermore, infrastructure debt is on RPMI's radar.
At ATP, the fund is split between a hedging portfolio and an investment portfolio. In the investment portfolio, which holds core government bonds including German bunds, duration has been shortened “a lot in absolute terms,” Mr. Svennesen said. “We cut the level of total risk taken (by the fund) in half in 2011 and have since reduced interest rate risk much further” in the past year. (ATP's investment portfolio is divided into five risk categories — interest rate, credit, equity, inflation and commodity — rather than specific asset classes.)
Mr. Svennesen added: “It will be difficult to make money by just being long 10-year government bonds right now.” Instead, ATP captures risk premiums associated with core government bonds in other ways. One example: taking forward positions along parts of the yield curve where valuations are more attractive.
Within ATP's hedging strategy, however, physical German bunds and Danish government bonds are continuing to be used in combination with interest-rate swaps denominated in Danish kroner and euro. Mr. Svennesen added: “In the hedging portfolio, we need (safe government) bonds. They're some of the only instruments that really give us exposure to interest-rate levels.”
Steven Meier, executive vice president and global cash CIO at State Street Global Advisors, Boston, said more institutional investors are considering cash and cash-plus strategies not only “to protect against a rise in interest rates but also (to guard against) widening of credit spreads.”
“Rates have one way to go, but the big question is when,” Mr. Meier said. If, for example, investors thought that interest rates would rise and had decided to move into cash three years ago, they “would have left a lot of yield on the table,” Mr. Meier added. “We could be in a low-rate environment for an extended period.”
