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By Jamie McGeever
LONDON, Feb 13 (Reuters) - As yields on top-rated sovereign and even corporate bonds dwindle and disappear, investors who have long relied on that steady, guaranteed income stream are taking bigger gambles to achieve a reasonable level of returns for their clients.
Keen to stay in the broad fixed-income universe rather than move into other asset classes like equities or “alternative” investments such as hedge funds, they are taking on more risk by buying less liquid bonds or debt with a lower credit rating.
This applies to a wide range of investors, from pension funds to central banks, who are finding it increasingly difficult to make money in an environment of deflation, zero interest rates and evaporating bond yields.
“Conversations with clients about changing mandates started about 18 months ago, but they have definitely picked up in the last quarter,” said April LaRusse, senior fixed income product specialist at Insight Investment, an asset manager owned by Bank of New York Mellon with 363 billion pounds of assets under management.
“This has been on investors’ minds for some time, but given how low yields are now, we’re expecting these conversations to become more frequent.”
Money managers are increasingly rethinking their strategies, something they have been doing since central banks first started slashing interest rates to zero and introducing bond-buying “quantitative easing” programs in response to the 2007-08 global financial crisis.
Pension fund assets at the end of last year were worth 84 percent of global gross domestic product compared with 54 percent in 2008, according to research firm Towers Watson.
Of that $42 trillion pile, defined contribution assets accounted for 38 percent and should overtake defined benefit assets in the coming years. That suggests investors’ scramble for yield will get even more intense than it already is.
The problem of lower returns has become even more acute thanks to the 50 percent collapse in oil prices in the last half of 2014. This drove down inflation and with it bond yields, which have gone from ultra-low to negative in some cases.
Some $7.3 trillion of government bonds and bills around the world provide a negative yield, according to Bank of America Merrill Lynch calculations.
All German government bond yields out to six years maturity and all Swiss bonds out to 10 years maturity are negative. Even the yield on Swiss chocolate-maker Nestle’s 10-year bonds briefly went negative last month.
But changing investment mandates isn’t done lightly or quickly. The client will discuss the mandate, then decide to change and go through the alternative investments with the money manager, who will then liquidate funds and implement the new strategy. This typically takes months.
But the pressure is building. Figures this week showed that the shortfall in Britain’s private sector pension plans rose to a record 367.5 billion pounds ($559.59 billion) at the end of January.
The total assets under management of 6,057 schemes tracked by the Pension Protection Fund (PPF) index were 1,274 billion pounds, while liabilities stood at 1,641 billion pounds. More than 5,000 schemes were in deficit, the watchdog said.
Pension funds have long-dated liabilities which they typically fund by buying long-dated assets. This means there is little scope for them to go further out the curve, so they are turning their attention to other areas of the bond universe.
Paul Cavalier, a partner at Mercer Investments in London, says that over the past couple of years clients have gradually shifted out of “core” strategies (such as buying government debt and investment-grade credit), into “core plus” (core, plus other geographies, higher yield and emerging market paper) then into “unconstrained” strategies (buying and selling a wider range of assets).
Evaporating bond yields, an unrelenting rise in stocks and a broad-based rally in most assets thanks to the $10 trillion of QE from central banks have altered the way investors should think now, Cavalier said.
“You should consider it ‘growth vs core’ as opposed to the traditional ‘stocks vs bonds’ way of thinking,” Cavalier said.
Still, highly rated government bonds are too large and liquid an asset class to ignore, despite these yields.
There are good reasons to hold them, to do with portfolio diversification, safe-haven protection and liquidity. They may also offer decent real returns, once deflation is taken into account.
Olivier Blin, senior vice president in Geneva at Unigestion, which has $16.7 billion of assets under management, recommends clients stay in government bonds but choose carefully.
“Yields can still stay low and generate positive returns, and you still need diversification away from equity risk,” he said.
“We’ve been looking at countries like Ireland. It might not be the best rated or considered the safest country in Europe, but it doesn’t pose the same credit risk as Italy or Spain. And it still offers good yield,” Blin said. (Reporting by Jamie McGeever; Editing by Larry King)