Investors Shedding Domestic Bonds, Bracing for Rise in Interests Rates
A new report, Asian Institutions Work to Reduce Fixed-Income Risk and Diversify Portfolios, from Greenwich Associates identifies two main priorities among institutional investors in Asia: Diversifying growing asset bases away from the domestic fixed-income investments that have traditionally dominated their portfolios, and managing risk in existing large fixed-income portfolios ahead of an expected increase in interest rates.
Asian institutions have made substantial progress in diversifying their growing portfolios. Still, outside of large sovereign wealth funds and endowments, institutional investors typically allocate more than half of their portfolios to fixed income. As a result, many funds find themselves focused on preparing portfolios to limit the damage rising interest rates could inflict in the short term.
“Reducing exposures to domestic fixed income and bringing portfolios into better alignment with global market capitalization is a process that in some cases will take a decade,” says Greenwich Associates consultant Abhi Shroff. “In the meantime, investors are making tactical adjustments to position their portfolios to weather cyclical market conditions as best they can in the context of their long-term strategies.”
Preparing for a Change in Interest Rates
Ninety-one percent of Asian institutions expressing concerns about interest rate risk say they are shortening the duration of fixed-income portfolios. The duration among Asian institutions now averages 4.2 years, down from 4.8 years in 2008. Institutions expect to modestly shorten average duration further to 4.1 over the next two to three years. In addition to shortening duration, 30% of institutions expressing concern over fixed-income portfolios say they are using derivatives to manage risk, with the typical institution hedging about a third of its fixed-income exposure in this manner. Fully 73% of the institutions not using derivatives to hedge say they are prevented from doing so by their fund’s investment policy.
Long-Term Diversification
Portfolio diversification has been the primary goal of many Asian institutions for several years, dating all the way back to well before the global financial crisis. They have made significant progress to this end over the past decade by reducing portfolio allocations to domestic fixed income and increasing allocations to international assets and alternatives. The market effect caused by soaring stock valuations over the last few years have provided an added boost to allocation shifts. All told, domestic fixed-income investments now make up just 23% of Asian institutional assets as compared to the 43% of assets they comprised in 2008. International bonds represented only 20% of total assets in 2008, but now stand at 34% of institutional portfolios.
Alternative Investments: Growing, but Concentrated
In 2008, Asian institutions allocated only 2% of total assets to alternatives. By 2012 that share had climbed to 10%. Over the past 12 months, alternative allocations grew further to 14% of total assets. The increase in alternative allocations, however, has been driven primarily by Asia’s largest institutions. Only about one in five institutions in the region invest in alternatives at all. “Alternative assets are concentrated in the hands of 20 to 30 large institutions that are active in alternatives — mainly state pension funds and sovereign wealth funds,” says Greenwich Associates consultant Markus Ohlig. “Most smaller Asian institutions have little to no exposure to hedge funds, private equity, real estate, and other alternative investments.”
Government agencies have made the most progress in diversifying their portfolios. In fact, the portfolios of Asian government agencies now include smaller allocations to fixed income and larger allocations to alternatives than most U.S. institutions.