A new policy environment is spurring a sense of optimism at Fonds de reserve pour les retraites (FRR), France’s pension reserve fund.
Executive director Olivier Rousseau, a long-time critic of grindingly low bond yields which he has called a “tragedy” for pension funds, particularly those forced to hold them due to regulatory conditions like FRR, can’t hide his enthusiasm for today’s environment of higher interest rates and fiscal tightening after a decade of financial repression.
For years, bereft of any returns, government bonds had become a volatility reduction tool or insurance in a risk-off climate, forcing investors to hunt for yields with lower quality fixed income. Elsewhere, it led to strategies that have now been exposed as risky, particularly hedging liabilities via LDI. Late last year many UK pension funds, prevalent users of the strategy, had to sell assets to raise cash to maintain the level of leverage needed to ensure they could hedge their liabilities when yields jumped sharply higher.
“LDI was protecting portfolios from the consequences of a further decline in interest rates when interest rates were already absurdly low and needed to go back into normal territory,” says Rousseau, who oversees a portfolio split roughly 70:30 to performance assets versus investment-grade bonds including French government bonds and other euro- and dollar-denominated bonds, plus unlisted assets.
Elsewhere he flags another risk area revealed by rising rates: “zombie” companies that have borrowed too much and will start to feel the shock of higher borrowing costs.
The long-awaited policy reset (after many false starts) means monetary policy is returning to normal. Interest rates are edging higher and fiscal policy has tightened, preventing governments indulging in binge borrowing because it now costs money to borrow.
The policy reset means that equities and bonds are an important source of diversification once again. “The arbitrage between interest rates and equities is back. We are in a normalised environment in terms of the policy mix,” he continues – although he cautions that a traditional 60:40 portfolio is still vulnerable to inflation.
If inflation surprises on the upside, investors will lose money on both equities (at least in the short term) and bonds.
“60:40 is a portfolio for a stable inflation regime or a modestly deflationary regime,” Rousseau says.
The new policy environment is feeding into strategy tweaks. For example, come the supervisory board’s asset allocation review in June, Rousseau notes a case for somewhat reducing FRR’s equity allocation in favour of high yield bonds, an allocation he calls something of a sweet spot.
High yields bonds are not overly vulnerable to inflation, and give a decent pick up over sovereign bonds, comparing favourably to investment grade credit. “The spread of high yield over investment grade more than pays for expected credit losses,” he says. Moreover, the lower duration of these assets also gives protection if inflation surprises on the upside.
Cashing in
Like many investors, FRR’s 13 per cent allocation to illiquid investments has provided some of the best returns in recent years. The portfolio has a French bias and includes investment in small-and mid-cap companies and French real estate. Built up slowly since 2013, and mindful of FRR’s liquidity constraints, Rousseau says last year the portfolio truly came right.
Recently FRR’s GPs have started to sell some individual stakes in the €1 billion private equity portfolio at significantly higher prices than where they had been valued, suggesting they had marked valuations at reasonable levels.
“It wasn’t a question of barking up the valuations and praying for validation,” he says, attributing success to good cooperation between the investment teams, management, and the governance. Will private equity continue its run? He says a small reversal this year is possible however if it happens, it will be limited.
Elsewhere the infrastructure portfolio has garnered stellar returns, also buoyed by a few sales. FRR’s small allocation to real estate (around €200 million) has also provided a steady return and the unlisted debt portfolio (€1 billion) returned a positive result. “This is good when you compare this to listed bonds which fell by 13 per cent,” he says.
“It would have been even better if we had succeeded in convincing the governance that there was also a strong case for select hedge fund strategies and insurance-linked strategies,” he reflects.
De-coupling
The policy reset may be fanning an easier investment environment, but Rousseau is mindful of key risks of which geopolitics, manifest in the increasingly fractious relationship between China and the west and ongoing war in Europe, is one of the most perilous. Mostly because of the challenge of finding protection and shelter for the portfolio if geopolitical tension snaps higher.
“Our portfolio has been constructed on the basis that all hell doesn’t break lose,” Rousseau says.
“Except, to some extent, holding US Treasuries and of course tail risk protections which are very expensive, there isn’t much you can do to protect equities and bonds if the Hormuz Strait is on fire,” he says, referencing one of the world’s most important trade routes. Adding, “geopolitics does not matter, except when it does. And today it’s not just neutral – not just noise.”
Positively, it is leading to investable trends (witness Apple’s boosted manufacturing operations in India, for example) that he says will bring increasing opportunities.
“Tapping into deglobalisation trends has very good days ahead of it,” Rousseau says.
And deglobalisation doesn’t mean that everything will be re-shored, he adds. Rather it means companies will build supply chains in countries they deem reliable and friendly.
Because FRR delegates to managers, the investor has no bearing on the day-to-day translation of these concerns on portfolio composition.
“I hope most of our managers are reducing their vulnerability to de-globalisation trends and adapting their portfolios to more recognised supply chains,” Rousseau says.
By law, all FRR’s allocations are managed externally either via mandates (around 80 per cent) or a subscription into collective open, or closed end funds.
Decarbonization
Rousseau’s other enduring concern is the lack of policy action around climate change.
“Governments must stop procrastinating. Policy action is coming, but it is coming too slowly,” Rousseau says, calling for regulation and carbon pricing that means it costs money for investors to hold polluting assets.
Rousseau says he is most encouraged by European disclosure regulation that will require European companies publish their climate exposure at a comparable level to financial disclosure.
“I hope there will be more similar initiatives in the rest of the world,” he says.
“This disclosure will reveal the big losers when the price of carbon finally goes up for real.”
Bad ESG premium
So far, 40 per cent of the equity and bonds allocation has been decarbonised and FRR puts additional demands on its managers every time it renews its mandates.
“It will keep coming down,” Rousseau says. However, like many other investors, he is concerned that divestment (without regulation) is leading to less responsible investors profiting from holding polluting assets.
Responsible investors, he says, are selling polluting assets only for them to be snapped up by other investors (hedge funds, family offices, some private equity, for example) not subject to the same regulation or stakeholder pressure.
This cohort of buyers only see carbon assets through a risk lens – and in the current environment “could have a nice run ahead” in what amounts to, in factor-speak, “a bad ESG premium”.
Only disclosure will reveal the true risk of holding these dirty assets, Rousseau continues.
“As long as carbon pricing remains too low, these investors can continue to hold these assets,” he says.
“What they are doing is mostly rational.
“Disclosure to the susceptibility of a hike in the carbon price is so important because these investors will react to this element. Everybody will see the risk picture more clearly.”
