Junk In Pension Funds: A Side Effect Of Financial Repression

The guest commentary below was written by Daniel Lacalle.

Misconceptions abound about collateral damages of financial repression. 

The first one is to believe that Central Banks monitor or react to financial risk accumulation. Policymakers tend to allow excessive risk-taking as a lesser evil side effect in their quest for inflation at any cost (read my paper). If asset valuations are somehow elevated, they expect a moderate correction to solve it.

Another misconception is to believe that risks accumulated during periods of monetary expansion can be easily absorbed and mitigated with macroprudential measures and regulation (Steiner et al). The evidence also shows that risk happens fast and the impact across assets and the real economy far exceeds the maximum impact estimated by commercial, investment, and central banks. The failure of stress tests and the inability to see financial bubbles or predict a crisis are a testimony to the mistakes in consensus complacent views of risk.

One of the biggest problems right now is that the most conservative and prudent investments are increasingly adding extraordinary risks for lower yields.

Take one of the flagships of conservative investment, the Norwegian pension fund. In its annual report, it shows that the fund has delivered a net real return of 3.27% and -7.74% in 2018, good relative returns, but what seems most interesting is that the overall performance has suffered just as equity investments rose from 20% to 69,32%. The increase in overall risk imposed by central bank financial repression has made global pension funds reduce bond holdings in favor of riskier and illiquid alternatives (Hentow et al, How do Public Pension Funds invest? From Local to Global Assets).

Not only are pension funds diversifying to riskier countries and assets, but they are also searching for yield in increasingly complex products and issuers with weaker solvency and liquidity quality (OECD Survey Of Investment Regulation Of pènsion Funds, 2018).

Making the lowest risk assets -sovereign bonds in OECD) extremely expensive through liquidity injections, asset purchase programs and cutting rates, is the equivalent of inflating a real estate bubble. An asset that is perceived to be safe and with stable qualities is inflated through demand-side policies and monetary support, and the risk accumulation spreads to other less-reliable and volatile assets.

Some concerning facts: Currently, there are only 60 basis points that separate “junk” corporate bonds from the highest quality high-yield ones, according to Morgan Stanley Wealth Management’s global investment committee. The amount of negative yielding debt has reached a historic high of $12.5 trillion. The number of negative yielding junk bonds in Europe has soared from zero to fourteen in a few months. Net inflows into junk bonds soared in June to $10.6bn, the largest increase over any such period since 2017, according to the Financial Times. Pension funds hold up to 30% of assets in illiquid products as well as equities. In Europe, demand from Asian -mostly Japanese pension funds- for risky peripheral Eurozone debt has also increased to the highest level since 2008 despite historic-low yields and rising political tension and fiscal imbalances.

The “search for yield” policy is similar to the risk outlined by professor Steiner in his 2014 paper: The persistent accumulation of reserves creates systemic risk. Pension funds are accumulating assets they perceive as safe compared to the inexistent yield of the domestic highest quality bonds, and by doing this, they are also adding into their portfolios the rising uncertainty and systemic imbalances built in other economies.

Most investors look at pension funds as the safest and most conservative option to build wealth over time and protect their savings, but many are probably unaware of the rising layers of risk that are being built into the asset base as managers are forced to move away from high-quality bonds to more volatile, risky, less safe and even illiquid assets in order to get a small yield out of their investments.

Policymakers may say that all this is only happening due to market demand, but when the central bank manipulates the cost and amount of money for a lengthy period of time while artificially eliminating the supply of low-risk assets through direct purchases and maturity repurchases, what they are effectively doing is the same as a misguided subsidy on a particular activity where demand is poor, creating a set of bubbles that will not be easily contained when they burst.

The fact that the most conservative investors are being forced to purchase bonds of nearly bankrupt companies for virtually no yield is not a success of monetary policy nor a tool for growth. It is a monumental monstrosity that will ultimately generate a crisis of unprecedented consequences.

EDITOR'S NOTE

This is a Hedgeye Guest Contributor note written by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and the most recent Escape from the Central Bank Trap.