Public funds from Japan look abroad in yield hunt

Global bond managers look set to be the next big beneficiaries of a hunt for yield that continues to drive public pension funds in Japan away from Japanese government bonds.

The allocation target for foreign bonds — for the country's ¥169 trillion ($1.52 trillion) Government Pension Investment Fund and other public funds — was boosted to 25% from 15% in the latest model portfolio unveiled by Japan's Ministry of Health, Labor and Welfare on March 31. The ministry updates target allocations for public funds with close to $2 trillion in assets every five years.

That gain came at the expense of domestic bonds, which saw their target weight drop to 25% from 35% in the model portfolio that took effect in April 2015. Prior to that, JGBs had pride of place in public pension portfolios with a 60% weighting.

Domestic equities and overseas equities held steady at 25% each. Five years ago, those asset segments more than doubled, making them the top gainers as the allocation to domestic bonds dropped to 35% from 60%.

Analysts said the latest model portfolio effectively finds public funds taking on more risk to secure the 1.7% inflation-adjusted annual return mandated by regulators.

Adding foreign currency exposure — as overseas bonds displace JGBs in portfolios — will push public funds further out along the risk spectrum, said a consulting veteran in the Asia-Pacific region who declined to be named. With the correlation of currency movements and equity prices over the past decade, that shift will spell more risk for the whole portfolio, he predicted.

Big public funds, in announcing their adoption of the new policy portfolio mix, made it clear they were moving more out of necessity than choice.

With extraordinary monetary policy easing pushing developed country yields to historic lows, it has become impossible to secure mandated real annual returns of 1.7% with the current policy mix, the ¥24 trillion ($216 billion) Pension Fund Association for Local Government Officials, known locally as Chikyoren, said in an announcement posted on its website March 31.

In late Asian trading on April 3, the yield on the 10-year JGB was -0.009%.

After JGBs, foreign bonds offer the next lowest risk as well as superior returns, the Tokyo-based fund added.

Global managers in Tokyo and the broader Asia-Pacific region said they have yet to see signs of an imminent flood of public pension fund allocations to overseas bonds, amid uncertainties surrounding the global coronavirus crisis and a changing of the guard at GPIF, which installed a new president Masataka Miyazono and a new chief investment officer, Eiji Ueda, on the April 1 start of Japan's new fiscal year.

Those new faces overseeing roughly three-quarters of Japan's pool of public pension assets may need some time before they're able to effect any changes in direction at GPIF, market veterans said. Messrs. Miyazono and Ueda "might need to get internal consensus from a governance standpoint as well as reassess market levels" amid such volatile and illiquid market conditions now, said the Tokyo-based head of one global money manager, who declined to be named.

Still, managers of overseas bond strategies insist there's reason to hope those business opportunities will come eventually, as and when signs of improvement emerge on the COVID-19 front — especially as market segments such as U.S. investment-grade bonds are offering spreads over U.S. Treasuries not seen since the global financial crisis.

News that foreign fixed-income allocations will rise to 25% while overseas stocks and bonds combined will climb to 50% of public pension portfolios "is obviously good for foreign managers like us," said Tetsuo Kushiya, Tokyo-based senior relationship manager with Eaton Vance Asia Pacific Ltd.

With dramatically wider spreads on offer now in segments like U.S. investment-grade and lower hedging costs, "I'd be very surprised if we don't see a significantly higher inflow from Japanese investors into global fixed-income markets this year," agreed Binay Chandgothia, Hong Kong-based managing director and portfolio manager with Principal Portfolio Strategies, the multiasset allocation boutique of Principal Global Investors.

Federated Hermes Inc., meanwhile, sees growing foreign bond allocations by GPIF — which under prior CIO Hiromichi Mizuno emerged as a global leader on environmental, social and governance issues — as potentially playing to two of the Pittsburgh-based firm's strengths — ESG investing and extensive fixed-income capabilities, said Jacob Nilsson, Singapore-based executive director, head of business development, Asia-Pacific.

If GPIF is looking for more foreign bond exposure and the fund's new management continues the "strong focus started by Mizuno-san around ESG, we feel relatively well placed to have that conversation with them," Mr. Nilsson said.

On March 31, GPIF reported that, as of Dec. 31, foreign bonds accounted for 18.1%, or ¥30.7 trillion, of its ¥169 trillion portfolio — potentially leaving room to add more than ¥11 trillion to that total to reach the new 25% target.

But if most observers believe GPIF is set to embark now on that sizable shift, at least one veteran analyst in Tokyo contends the move may already be largely complete.

That's partly because the savage plunge in domestic and global equity valuations since late February — when efforts to contain the coronavirus began shutting down large swathes of the global economy — effectively lowered the amount public pension funds needed to redirect to global bonds to put those asset segments on par with one another, said Takafumi Yamawaki, a Tokyo-based executive director and head of Japan rates research with J.P. Morgan Securities Japan Co. Ltd.

Between Dec. 31 and recent market lows on March 23, GPIF's overseas equity benchmark, the MSCI ACWI ex-Japan, plunged 32.7%, while its TOPIX benchmark for domestic stocks tumbled 24.9%.

In addition, Mr. Yamawaki said he estimates GPIF shifted roughly ¥3 trillion into foreign bonds through late March, on the back of data showing record purchases of foreign bonds by trust banks, largely on behalf of pension fund clients, in January and February.

That boost in allocations combined with an equity sell-off that shaved an estimated ¥25 trillion off of GPIF's portfolio value would bring the pension fund's overseas bond allocation to around 23.6%, said Mr. Yamawaki.

While managers concede the equity sell-off would cut into the scale of allocation shifts needed to move toward that 25% target, most believe considerable flows into foreign bonds can still be anticipated.

Perhaps with that sell-off, a 10-percentage-point shift into global bonds is closer to 5 or 6 percentage points now, noted Mr. Chandgothia. For a $1.5 trillion fund, that would still be $60 billion to $70 billion, he said.

Meanwhile, if rebalancing to meet new policy portfolio targets is a stock question, how to put continued flows into GPIF and other public funds to work is a separate matter, Mr. Chandgothia said. In the future, a greater portion of those incremental flows will go to U.S. fixed income or other non-Japanese paper, he said.

Mr. Yamawaki conceded a two-step process could be at work, involving public pension funds quickly moving for now into the most liquid overseas market — U.S. Treasuries — with plans to gradually move into smaller market segments, like credit, in subsequent months or years.

To diversify their portfolios, big public pension funds like GPIF will need to hire new managers, a process that will require "considerable runway" to execute, said Federated Hermes' Mr. Nilsson.

Meanwhile, the largest public funds are leaving themselves plenty of room to reduce JGB weightings well below their policy portfolio's 25% target.

Chikyoren announced its JGB allocation can range 20 percentage points on either side of its 25% target, meaning it could hold as little as 5% in domestic bonds before having to rebalance.

GPIF established a smaller range of 7 percentage points on either side of its 25% JGB target, but retained two escape hatches the fund put in place over the past year to allow for even lower allocations — counting yen-based cash holdings and yen-hedged foreign bonds as domestic bond holdings.