Investors favour credit

Towers Watson’s negative outlook for bonds and its advice to increase allocations to high quality credit is being reflected in portfolio shifts by institutional investors.

The consultant issued a downgrade of intermediate global government and inflation-linked bonds that typically have a 10-year maturity, describing them as “highly unattractive” and offering little or no risk premium over cash for investors.

Robert Brown, chairman of Towers Watson’s global investment committee, advises investors with a diversified portfolio and a cash benchmark to reduce the duration risk of these bonds by shifting funds towards cash and high quality credit to maintain the overall risk profile of their portfolios.

Brown says pension funds with defined liabilities invested against a long bond-like liability should also look to adjust their fixed income portfolios in light of the Towers Watson’s negative view on bonds.

“Given bonds at most maturities are unattractive at the moment, our general view is that a controlled short interest rate position relative to a fully hedged position is sensible, consistent with the size of other risks within the portfolio,” Brown says.

“If investors are well below a fully hedged position, it is still appropriate to increase the amount of hedging. This reduction in rate and inflation risk relative to their liabilities could be recycled by buying high-quality credit.”

Flows into bond funds hit record levels in the first month of the year, according to EPRF Global, a global fund flow tracking research firm.

In January (Spell out) EPRF reports that flows into bond funds surged to levels last seen in the second quarter of 2011. Investors looking for yield committed to high yield bond funds and extended a seven-week run on Europe bond funds not seen since May 2010.

In its most recent analysis in February EPRF noted that investors were also looking to increase their risk profile in the wake of a more policy certainty in Europe and potential green shoots emerging from the languid US economy.

Mortgage-backed bond funds enjoyed record setting inflows, while high yield bonds continued their strong run of inflows.

Weekly cumulative inflows into bond funds have continued to increase strongly since October last year, and now stand at more than three times the levels in the fourth quarter of 2011.

This increase is in the face of strong equity markets with the Dow Jones touching 13,000 points earlier in the month. The Dow is up 6.2 per cent and the S&P 500 9.3 per cent so far this year.

Outlook reflected in portfolio shifts

Towers Watson’s outlook is being reflected in the portfolio shifts of large investors.

CalSTRS is one large institutional investor that has reduced its exposure to government bonds.

In its most recent quarterly investment report into fixed income handed down at the end of last year, CalSTRS reports that it lowered its exposure to sovereign debt and looked to diversify its fixed income holdings.

As of December 31, 2011 its holdings of government bonds was more than 8 per cent underweight CalSTRS’ policy benchmark.

The $140.9 billion-Californian public pension fund was more than 2 per cent overweight relative to its policy benchmark in both high yield and its “other” category of fixed income, which includes bank loans, emerging market debt, non-dollar bonds, and derivatives.

Its fixed income holdings currently make up more than 17 per cent of its overall portfolio.

“We continue to believe that an overweight to spread (non-government) product will generate better relative returns over the benchmark, given our continued expectation for modest growth,” the quarterly report states.

“We are also maintaining a bias towards higher quality assets as a defensive measure, with expectations for continued market volatility.”

Towers Watson’s negative outlook for bonds is in line with its view that the combined effects of money printing by central banks and strong flows into so-called safe assets has pushed intermediate bond risk premiums to very low levels.

“We think they now offer a very low risk premium over cash and/or are discounting a high probability of a macroeconomic backdrop of 10 to 15 years of economic stagnation,” Brown says.

“This is too pessimistic in our view and our forecast returns suggest bonds are now unattractive.”

Towers Watson does not share this negative outlook for the world economy, with its research predicting that private sector deleveraging problems will diminish in the medium term.

This could lead to a stronger and faster cyclical recovery than most intermediate bond markets appear to be pricing.

Despite more risk appetite beginning to return at the start of the year, Towers Watson sees that deleveraging, loose monetary policy and flows into so-called safe bonds will continue in 2012 and result in ongoing low bond yield and bond risk premiums.

The strong start to the year in equity markets has elicited a caution from Towers Watson, which has downgraded its outlook for equities from “attractive” to “neutral”.

In its most recent weekly investment report, consultant Russell Investments questioned if global equity markets had “gone too far” in the light of the dark clouds still hanging over the global economy.

Brown says valuations are currently broadly fair, while major near-term global economic problems remain unresolved.