Sovereign funds’ message for regulators
by Philip Turner
Twenty years ago, Norway’s sovereign fund was wholly invested in government bonds. Since then, it has cut the share of bonds in its portfolio and increased its equity exposure. This strategic investment choice has been reinforced by the extremely low bond yields of the last few years.
It is hard to exaggerate the magnitude of the recent shift in the world interest rate environment. Expansionary monetary policies since 2012 have depressed the world nominal long-term rate of interest to below 2%. The term premium declined to minus 1% from 1%, as the Chart shows. Bond investors will get lower returns over the next 10 years than if they had invested in short-term paper.
For many, the message from such a market environment is to get out of bonds. Following recommendations from a government-appointed committee, the benchmark share of equities in Norway’s government pension fund increased to 70% from 60%. As a long-term investor, its objective is to achieve long-term real returns. It does not need to seek highly liquid instruments with no credit risk, and investing heavily in such instruments would lower their future returns.
Persistence of low long-term rates
The recent behaviour of private sector institutional investors, however, has been the exact opposite of that of Norway’s fund. They have, in general, increased the proportion of bonds in their portfolios even as term premia sharply declined.
New rules and accounting practices have encouraged increased holdings of long-term bonds relative to equities, even as bonds offered gradually lower yields. The spread of mark-to-market accounting principles – which relate to the system of valuing assets by the most recent market price – requires firms to revalue regularly assets and liabilities as prices change. In practice, this means pension funds need to price their assets as if they had to be sold tomorrow. This may be prudent because shocks could force the find to close, which is not a problem the Norwegian pension fund would face.
International accounting standard No. 9 requires the discounting of defined benefit pension liabilities by a bond yield. However, this ‘liability-driven’ strategy entails a shift into long-term bonds out of equities. Though this may make sense for a single fund, it is not desirable at the macroeconomic level.
Institutional investors have been compelled to lengthen the maturity of the bonds held on their balance sheet. The European Union’s Solvency II directive similarly pushes European insurers to hold more government bonds, accentuating interest rate risk. The consequence is that the portfolios of institutional investors have become more dependent on longer-term interest rates than they were before the 2008 financial crisis. The size of such exposures cannot be precisely measured, though estimates have been made. The rating agency Fitch calculated that, if bond rates were to return to their 2011 yields, fixed income investors could lose $3.8tn.
The consensus is that long-term rates will stay low for years. But it is possible that current yields are overshooting the long-term equilibrium. There is evidence of procyclical dynamics of many institutional investors: to keep up average yields, they go even longer when the 10-year rate declines, so push long-term rates lower. There are reasons for thinking that market liquidity will evaporate in a bond market downturn, with yields spiking.
Learning from sovereign fund principles
All firms, aware of how interest rate exposures everywhere have risen, will act quickly to limit their bond holdings once interest rate sentiment changes. A further threat to global bond portfolios may come from the higher share of non-core and illiquid segments, such as emerging market bonds. In a crisis, investors may decide to delay crystallising losses by selling their more liquid securities. A sudden jump in bond yields would be more likely to lower the total market value of the financial assets of private pension funds than in the past. The accountants responsible for auditing their accounts might say, ‘Don’t worry, the present discounted value of the pension liabilities has also fallen.’ But some who dig a little deeper might ask: what explains the better performance of Norway’s government pension fund?
Several factors contribute to the better performance of Norway’s government pension fund. As a public institution that does not face the risk of bankruptcy, it is able to take its function as a long-term investor more seriously. Similarly, the Norwegian sovereign fund is not constrained by those accounting rules designed for private sector investors.
Aware of these problems, Avinash Persaud, chair of financial analytics firm Intelligence Capital, proposed in his book Reinventing financial regulation an alternative to mark-to-market accounting principles, which he called ‘mark-to-funding’. This system states that assets matched with long-term funding should be priced according to their long-term cash flows. This would not be simple to implement, since such cash flows are unobservable. The issue of bankruptcy preventing a firm lasting long enough to reap the long-term cash flows would remain.
Nevertheless, the question of how to do better than mark-to-market still needs consideration.
Philip Turner is Visiting Lecturer at Basel University and former Deputy Head of the Monetary and Economic Department at the Bank for International Settlements.