With overvalued sovereign bond markets, how do you go defensive?

With continued, or even increased, nervousness surrounding the short-term future for most markets, the question of risk mitigation has once again come to the fore for institutional investors. But for defined benefit funds, in particular, this is an especially curly question.

Observers are getting ever-worried about perceived overvaluations in most sovereign bond markets. Mercer Investment Consulting in the UK, for instance, sent out a bulletin last month warning of “extreme valuation” in long-term UK gilts.

In the US and other countries, except emerging markets and those tied to their fortunes, the story is the same. Government bonds are overvalued.

But, if you are running a DB fund and want to apply some extra protection against a double-dip recession or significant equities market retraction, what do you do?

Well, there are various protection strategies available without going too long sovereign bonds. But all of them come at a price. Credit looks fairly valued at the moment, to the extent that that represents a defensive asset. And real assets are still probably at near their best buying for several years.

The latest Mercer Investment Consulting report on medium-term asset allocation for UK pension funds, suggested gilts – of any duration – were overvalued and index-linked gilts were extremely overvalued. The consulting firm, however, says UK equities, global equities and UK property are fair value.

A study by Towers Watson of 109 organisations which have DB pension funds found that a surprisingly small proportion, 14 per cent, had increased their allocation to all fixed income during 2009. An even smaller proportion, 8 per cent, planned to do so this year, and 19 per cent said they would consider lifting their fixed income exposure in the future.

While the survey of those Canadian funds was taken in March, one suspects that the results would be even more edifying now, in August.

The Towers Watson survey is primarily about risk, but most of the respondents seem to be looking for other risk-mitigation factors than changing their investment allocations. Only 27 per cent said they had taken action to contain investment volatility in the past year and 25 per cent said they would do so this year.

More of the funds said they were looking to increase the duration of their fixed income exposures than lift the stated allocation. This should sound alarm bells for both the plan sponsors and their regulators.

If the longest sovereign bonds, generally, are ‘extremely overvalued’ then DB funds look like mugs if they tilt their fixed interest portfolios in that direction.

What the Towers Watson survey results indicate, however, is that in Canada at least, regulatory reform is needed if DB funds are to continue.

The survey respondents, and Towers Watson, believe that governmental pension reforms will be critical to the sustainability of private sector DB schemes.

That could probably be said for many countries other than Canada.

Greg Bright is the Beijing-based publisher of Top1000Funds.com