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Next Stop: Complexity and Illiquidity

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Stockholm (HedgeNordic) – Stuck between low yields, the prospect of higher rates due to rising inflation and the need to include fixed income in their portfolios, institutional investors face a difficult task in deciding where to allocate capital. “The major challenge for all the institutional investors in this environment is that there are no diversifying asset classes,” confirms Kari Vatanen (pictured), the chief investment officer of Finnish pensions insurer Veritas.

“Looking back over decades, fixed income, especially government bonds – the risk-free or almost risk-free investment, has been a good diversifier in history,” says Vatanen. “With the zero-rate environment in the Euro area and low rates in the U.S. post-financial crisis, the fixed-income space does not provide a lot of diversification potential for investor portfolios.” With inflationary pressures worldwide and the prospect of higher target rates from central banks, an already challenging market environment has become even more difficult for institutional investors.

“The major challenge for all the institutional investors in this environment is that there are no diversifying asset classes.”

“There are strong inflationary pressures especially in the U.S. but also in Europe, which means it is quite probable that central banks will tighten monetary policies,” argues Vatanen. Markets are already pricing three rate hikes by the U.S. Federal Reserve for 2022. “If inflationary pressures continue, and rates will be rising in response, that means negative returns for risk-free fixed income,” points out Vatanen. “That is a difficult environment for fixed-income investors, especially for those who are required to maintain an allocation to risk-free instruments.”

Like many other institutional investors, Veritas Pension Insurance is subject to regulatory requirements that force the pension insurer to invest a portion of its assets in low-risk fixed-income investments. “We cannot allocate all the assets in risky asset classes such as equities or equity-type of investments,” says Vatanen. “Even in illiquid cash flow-generating asset classes such as real estate and infrastructure, we have a limited possibility to allocate there due to regulation,” adds the CIO of Veritas. “We are required to stay in fixed income in one way or another, and that represents a little bit of a challenge in the current environment. But we need to take it from here and constantly think of what we can do.”

“During the last decade, we have tilted our portfolio towards lower credit quality, meaning higher yield, but we might be at the end of that path already.”

“We cannot be totally out of highly liquid risk-free government bonds due to several reasons,” argues Vatanen. “We need them to meet regulatory requirements and we need them for liquidity risk management,” he elaborates. “We need to have an allocation in the high-liquidity instruments to be quite sure that we can get liquidity out in every possible time,” says Vatanen. “During the last decade, we have tilted our portfolio towards lower credit quality, meaning higher yield, but we might be at the end of that path already.”

Current Objective: Decrease Duration

With the prospect of rising rates due to inflationary pressures, the primary goal for institutional investors is to lower duration in the portfolio of fixed-income investments to limit the impact of rising rates. “The next step we are taking is decreasing duration, or the interest rate sensitivity of the portfolio in the environment where we expect rates to rise in the face of inflation and central bank actions,” confirms Vatanen. “But the problem is that target rates in the Euro area are negative, which means that keeping money in cash is not a good choice for institutional investors.”

“The next step we are taking is decreasing duration, or the interest rate sensitivity of the portfolio in the environment where we expect rates to rise in the face of inflation and central bank actions.”

This environment also forces institutional investors such as Veritas “to hunt for yield in more risky asset classes within the fixed-income space, which means higher exposure to credit risk but also extra complexity and illiquidity from opportunistic credit or illiquid debt asset classes,” says Vatanen. “That is a common challenge for all institutional investors,” he emphasizes. All institutional investors are hunting for yield and this is not in any way a new phenomenon. “We have been in this kind of environment five years or even more. With interest rates so low, investors have been forced to hunt for yield, but that is now even more problematic due to higher inflation expectations.”

The objective, therefore, is to “build a portfolio with lower duration and lower interest-rate sensitivity, but at the same time we have hunt yield in asset classes that are not interest-rate sensitive,” argues Vatanen. “We have to shorten duration in the total portfolio and hunt down for yield by going down in the risk spectrum,” reiterates the CIO. However, higher-risk interest-floating instruments such as high-yield bonds, which help decrease portfolio duration, are not offering appropriate compensation for the risks associated with these investments, according to Vatanen. “High-yield spreads in the market are starting to be quite low, meaning that there is more risk than yield available in the high-yield market. Again, this forces us to find other places in the fixed-income space.”

“High-yield spreads in the market are starting to be quite low, meaning that there is more risk than yield available in the high-yield market. Again, this forces us to find other places in the fixed-income space.”

Veritas and other institutional investors required to hold assets in fixed-income mainly have two alternatives. “One alternative is illiquidity, which involves opportunistic credit, illiquid credit or private debt-type of investments, and the other is complexity,” says Vatanen. “We try to find more complex structures to get yield without duration, interest-rate sensitivity.”

“One alternative is illiquidity, which involves opportunistic credit, illiquid credit or private debt-type of investments, and the other is complexity.”

Although real estate and infrastructure are often considered the go-to asset classes in an inflationary environment, Kari Vatanen argues that the current environment is difficult for these asset classes too. “The cash flow generation from real estate and infrastructure is attractive for the investors seeking a replacement for fixed-income investments,” argues Vatanen, who goes on to emphasize that “they are not totally risk-free in an environment of rising rates.” According to Vatanen, “there is a lot of implicit duration included in such kind of cash flow-generating investments, which means that the whole inflationary environment is quite challenging.”

Inflation Isn’t as Temporary as Expected

Global inflation, initially believed to be a temporary phenomenon caused by the reopening of the global economy and then by supply chain disruptions, has been on a roller-coaster ride since the beginning of the coronavirus pandemic. Investors are increasingly arriving at the conclusion that inflation is not as temporary as initially expected. “To be honest, our own view on inflation has changed in the previous couple of months,” acknowledges Vatanen. “We have observed three waves of inflation. The first wave was demand-based inflation, which started at the end of last year,” starts the CIO. “The biggest driver was fiscal support packages from the U.S government meant to keep the economy going.”

“But now it seems inflationary forces have gone stronger with wage inflation.”

The second wave started this summer with supply chain disruptions. “We have seen and continue to see bottlenecks and supply chain disruptions that are causing rising prices, which creates supply-side inflation,” explains Vatanen. “I have not been worried about these first two waves,” he emphasizes, as the forces behind the demand-driven and supply-driven inflation were only temporary. “But now it seems inflationary forces have gone stronger with wage inflation,” says Vatanen. “There is higher demand for labor than what is available in the market and that, of course, serves as a tailwind to wage inflation,” he continues. “That might be the reason why inflation is not that temporary. Wage inflation means that we have constant inflation. It is not temporary.”

 

This article features in HedgeNordic’s 2021 “Alternative Fixed Income” publication.

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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