The International Monetary Fund’s Global Financial Stability Report released in mid-October sounds some loud warning bells. Take, for instance, the volume of bonds now delivering negative yield, which the IMF puts at US$15 trillion. Allied to that figure is the expected $19 trillion of corporate debt-at-risk, or the amount owed by firms unable to pay their interest expenses from earnings. The IMF says this accounts for nearly 40% of total corporate debt in major economies.
All this underlines the eager appetite among pension funds and other institutional investors for higher-yielding assets, notwithstanding the commensurate risk.
In particular, the IMF says institutional investors are running greater risks and diluting their customary stabilising role in the financial markets with their rush into private equity and other alternative assets, warning of “grim implications for financial stability”. Defined-benefit pension plans especially, faced with rising future obligations versus falling interest rates, have “increased their exposure to long-duration assets, taking greater illiquidity risk in exchange for higher returns” by investing increasingly in alternatives, the report says.
According to IMF data, the weighted average allocation to alternative assets among major pension funds has risen from more than 5% of their portfolio in 2007 to just over 20% in 2017-18. And that is an average figure. For some of the more enthusiastic allocators to alternatives, the figure is over 30%.
There are quite a few lessons from the global financial crisis that have apparently been unlearned or forgotten since 2007-08. For one thing, the crisis demonstrated that private equity is no kind of uncorrelated hedge against the risk of a crisis. Whatever the asset class’s claims to ride out the ups and downs of economic cycles, if a major macro crisis or recession hits, the value of private equity assets will be dragged down along with the rest of the market.
Furthermore, pension funds and other institutions that mark their asset values to market will be faced with slumps in the book value of their private equity assets, but with only limited opportunities to exit or reduce their exposure. And remember that extremely high allocations to private equity did not protect the portfolios of US university endowments and other fans of the asset class during the crisis. Harvard University endowment, for one, took a 22% loss in its portfolio value in December 2008, with forward losses calculated at up to 30%.
The IMF also warns that the current hunt for yield is making institutional portfolios more and more similar, exacerbating the impact on the global financial system if all those portfolios are hit with a sudden market shift. Even their liquid assets may be at risk.
For roughly 20% of global pension fund assets under management, the “estimated capital commitments related to alternative investments are more than half of their liquid assets”, the IMF says. It’s calling for greater supervision of non-bank financial institutions to mitigate the risks. That can’t come soon enough.