This article was originally published in Project M, an Allianz Global Investors international pensions publication featuring unique perspectives on investments and retirement.
The specter haunting investors is financial repression, a deliberate policy by governments to keep interest rates artificially lower than inflation. Needing to service gargantuan levels of public debt – significant amounts of it stemming from private-sector bailouts during the financial crisis – governments have passed on the burden to savers.
By pushing nominal yields below inflation and channeling the resulting cheap money towards themselves, governments aim to inflate their debt away over the years. The problem with financial repression is that, unlike many past specters invoked to scare the public, this one is real and causing havoc for investors. As Andreas Utermann noted in the last edition of PROJECT M (‘Taxation by stealth’) financial repression represents a redistribution of wealth from the prudent to the indebted. Savers around the world can now watch as painfully low interest rates corrode the value of their bank accounts. Governments are also using various tactics to encourage captive audiences, such as banks, pension funds and insurance companies, to buy their debt.
For example, in Germany, life insurers are obliged to invest in safe assets. In the last five years, the yield on bonds outstanding – the benchmark for a safe investment – has dropped from 4% to 1%. This lowered performance hits people who may have a participating payout annuity where benefits depend on investment performance.
The net return on capital investments of German life insurers has dropped from an average 7.5% throughout the 1990s to 4% in the past few years. In the United Kingdom, where the Bank of England embarked on a £375 billion ($601 billion) money-printing policy in 2009, annuity rates have plunged to their lowest level since records began.
The story is also grim for pension funds. With falling yields, especially at the long end of the curve, the present value of future liabilities has risen steadily, possibly leading to funding shortfalls. This applies especially to pension funds that are required to value their liabilities on a mark-to-market basis such as in the Netherlands. There, 260 of the country’s 317 pension funds, representing 95% of all plan members, failed to meet the minimum funding requirement (De Nederlandsche Bank). This could translate to benefit cuts in the near future. In France, the compulsory pension scheme Agirc-Arrco was confronted with a funding deficit of €119.2 billion ($153.75 billion) by 2030, before the social partners agreed on benefit cuts.
In real, inflation-adjusted terms, high- quality sovereign bonds have become too expensive for the long-term, concludes Franck Dixmier, CIO of fixed income Europe at Allianz Global Investors. “Total return expectations are extremely low and could even be negative for bonds, such as US Treasuries or German Bunds,” he says. As a consequence, investors in search of higher returns need to seek outside the high- quality sovereign bond market. Yet, investors are also strongly risk-averse, having been savaged by the financial crisis and been burnt on write-downs of debt to Greece. So, with no hint that financial repression is likely to end any time in the next few years, Dixmier believes investor interest in corporate bonds, as well as in emerging market bonds, is likely to continue.
“We know, from statements of the European Central Bank and from what the overnight interest rates on a forward basis are telling us, that markets are absolutely buying the scenario of a low-yield climate for a long time.”
An alternative for institutional players is infrastructure or loan markets. These could provide alternatives for institutional players as the investment durations match well to the long-term requirements.
“One significant trend is that, as banks are deleveraging, they are seeking partners to cooperate in investments and to co-finance corporates.” Yields can vary, but opportunities abound, Dixmier says.
One potential area likely to cause shudders among institutional investors who have grown gun-shy is sovereign debt. While Dixmier, who has 21 years of experience in fixed-income markets, can understand the mindset given the losses involved with Greece, he believes a special case can be made for Spain and Italy.
“Italy and Spain, both under market pressure, are experiencing different situations: Italy is suffering from a liquidity crisis, while Spain is facing a true problem of solvency. In a context where we now have credible support schemes in the euro zone, our view is more constructive and we are building additional exposure in our portfolios; in Italy, despite some political uncertainties, our scenario in the medium term is a normalization of yields.”
Dixmier argues sovereign debt yields in troubled peripheral countries of the euro zone have fallen sharply since June 2012. Partly this has been inspired by creditable commitments to the European Fiscal Compact, an accord on euro-zone budget discipline.
Subject to strict conditions, the ECB has also committed to buying without limit short-term government bonds of countries applying for assistance. This is a ‘game changer’ in his view, empowering the ECB with a powerful tool similar to that used by other central banks. A move to form a euro-zone banking union, based on a June declaration “to break the vicious circle between banks and sovereigns,” has also played a role in allaying market fears.
Benefits to Convertibles
While convertible bonds are a niche market, they present a compelling case for some institutional investors. Given current yields, investors could be exposed to substantial losses with even modest increases in bond yields. Convertible bonds – a hybrid security with both debt- and equity-like features that can be exchanged for a predetermined amount of equity in a company – can provide a measure of protection.
Analysis run by Dixmier’s team on the Euro Stoxx 50 since 1996 (see chart) showed investors in convertibles during a time of positive markets had participated in half of the performance of the equity market during that time. While investors were also exposed to losses, they were only exposed to a third of the losses of the equity market under adverse conditions.
Over this period, this study shows that convertibles had a favorable risk/reward profile, which may make them an attractive complement to a traditional fixed-income portfolio.