PGGM, the asset manager for €237.8 billion PFZW, the Netherland’s healthcare pension fund, invests around 30 per cent of PFZW’s assets in fixed income with another 10 per cent allocated to liquid corporate credits. Portfolio manager Wilfried Bolt tells Top1000funds.com how the end of quantitative easing (QE) has changed PGGM’s hedging strategy and prompted a keen focus on liquidity. He also explains the rationale behind managing more of the corporate bond allocation in house.
Hedging the risk
Today’s new economic regime of higher interest rates has impacted PGGM’s hedging strategy, a carefully choreographed approach designed to keep PFZW’s coverage ratio stable by matching its liabilities and assets daily.
“We invest in long-term maturities with typical maturities of 20- to 30-years but could include up to 100-year maturities,” explains Bolt, who has been at PGGM for 13 years. “Fixed income is the cornerstone of the investment portfolio. The required investment returns are typically calculated versus the risk-free rate, so we only invest in government and SSA bonds with a minimum AA-rating.”
The end of central bank bond buying program means the yield curve is finally starting to steepen again. It is a reversal of a trend dating from 2014 when curves first began to flatten off the back of massive European Central Bank intervention that continued up until last year when the ECB stopped re-investing part of their asset purchases.
“In our strategy we have been anticipating this steepening,” says Bolt. “The inverted 10- to 30-year swap curve means our preference when it comes to hedge duration has focused on these middle maturities rather than longer-dated maturities, ever since 2022.”
The end of QE has also turned PGGM’s focus to liquidity – namely ensuring the continued ability to buy and sell bonds now that the liquidity central banks injected into the market is over. “The ability to access bonds as collateral for central-clearing activities under our derivatives operations has become more prominent on our radar,” he reflects.
Similarly, he says liquidity is also becoming much more important for other market participants, visible in corporate and sovereigns increasing benchmark issue sizes or tapping existing bonds. “This is one of the effects of reduced intervention by central banks that can be observed over the last years,” he says.
Swaps v bonds
In another trend, the disappearance of QE is impacting the yield differential between swaps and bonds, which PGGM manages in one integrated mandate. It has created a window of opportunity to either pick bonds when the team think they are attractively priced or buy swaps if they expect swap spreads to tighten.
“Scarcity of safe bonds was a remarkable phenomenon in 2022, making them extremely expensive versus swaps. Consequently, most of our hedging since then has been executed via swaps. It’s resulted in quite a large net liquidity position to potentially invest in bonds when swap spreads reach a level we deem attractive enough [to invest more in bonds]”
Now that central banks have switched to tightening mode, private investors must absorb huge supply. “As in 2023 we don’t see any hint these amounts cannot be absorbed by the market, however the time when bonds underperform swaps could continue potentially further into 2024,” he predicts.
Bolt reflects that a hard landing could bring more demand for government debt (also more supply) if investors switch out of riskier assets into safe havens once again. It could also see central banks re-emerging as buyers of sovereign bonds. In another scenario, a softer landing would have more ambiguous implications. It could see demand for the safest havens and less demand for smaller issuers, for example. “In both cases, we expect more demand for short-dated government bonds than the ones further out on the maturity spectrum.”
Shaking up corporate credit
PGGM is also changing its approach to corporate credit, covering a wider range of segments in-house. This includes US dollar-denominated corporate bonds, but also in-house coverage of high yield companies, both in the US as well as Europe.
“Taking a global approach makes a lot of sense.,” he says. “We believe covering the entire corporate credit universe, both across currencies and countries as well as across rating segments, allows teams to better take advantage of inefficiencies between the pricing of individual segments. Overall allocations to credit as an asset class have remained stable recently.”
Although he says the corporate bond market is “in relatively good shape,” he flags areas where those inefficiencies and risks are starting to manifest. Namely real estate companies, a segment with large corporate bond exposure and most exposed to the rapid increase in interest rates.
“We have had concerns about both valuations and corporate governance in some real estate firms, especially in Scandinavia. Investor appetite for bonds from such companies quickly dried up, resulting in a significant underperformance especially in so called hybrid instruments.” Going forward he expects the market to start differentiating between the different issuers much more.
Another segment of the market attracting his attention is high yield, especially in the US. High yield spreads still trade at comparatively tight levels versus their investment grade peers, while the ability of a lot of these companies to access the bond market has been hampered.
“With a sizeable amount of refinancing coming up in the next two years, it is likely that companies will need to pay significantly more for funding than what they were used to in the past years of low interest rates, thereby reducing profitability, leading to a normalization of spreads.”
Geopolitics in the bond market
That global approach and managing the allocation in house also helps navigate the impact of geopolitics playing out in the bond market. For example, he describes “excessive demand in euro markets” for scarce, safe, German government debt up until 2022. Since then, the pressure on German bonds has started to alleviate creating tighter spreads for other European sovereign bonds.
Still, he notes that the impact of geopolitics on the investment grade credit market has been surprisingly small. Mostly because the market has been more preoccupied with the path of interest rates on both sides of the Atlantic, pricing in aggressive rate cutting cycles for this year, despite pushback from various central banks. “The interplay between economic activity and inflation numbers seems more on the minds of investors than the various geopolitical risks that are present.”
Integrating sustainability
PFZW invests at least 5 per cent of the fixed income portfolio in bonds that contribute towards achieving the SDGs. But progress moving from investing in specific named SDG issuance to analysing sovereigns on an issuer level, is slow.
“In 2023 we started to calculate financed emissions for investing in sovereign bonds via PCAF’s updated standard but a more complete 3D assessment of our sovereign bonds, potentially as a tool to have a more meaningful exchange with the sovereigns we invest in, is still a work in progress,” he says. Moreover, green and social bond frameworks and initiatives to standardize sustainability-related bond issuances are only effective if multiple, large investors pool their weight and voice.
Still, outside the SDG bond programme, the team are making progress integrating PFZW’s sustainability goals via a carbon reduction pathway and an emerging 3D-investment framework that evaluates risk, return and sustainability of an investment.
It is also getting easier to integrating 3D investments in corporate bonds. For example, the team now measure the sustainability of individual business models and the sustainability targets that a company has put in place. PGGM is also prepared to buy labelled bonds from companies including companies that are ‘transitioning’ if they have presented a credible path to future sustainability.
He concludes that PGGM is more prepared to get increasingly tough on corporates. “If companies fail to deliver on such promises, we have no hesitation in divesting from them. We have become much more selective deciding which companies we engage with, based on where we think we can have a good chance of success. This more selective approach has helped to improve the success rate of our engagement efforts.”
