Japan’s corporate pension funds are abandoning the safe harbour of Japanese government bonds (JGBs), but in their search for more attractive yields and greater diversification they must increasingly consider new challenges such as currency risks and spreading economic weakness.
While Japanese corporate pension funds have increased their share of alternatives investments, their allocations to JGBs have plummeted to 18.1% from 30.3% four years ago, shows an annual survey* by JP Morgan Asset Management.
For the first time in the study's 12-year history, average pension fund allocations to alternatives (21.3%) surpassed allocations to domestic Japanese bonds (18.1%) (see chart below). Returns on JGBs have been meagre due to Japan's prolonged negative interest rate environment.
According to Masaharu Takenaka, professor of economics at Ryukoku University in Kyoto, the stampede away from JGBs makes perfect sense for the pension funds. His assessment is that they have no use of investing in JGBs for the time being, especially long-term bonds, because their yield is zero or negative.
“For these pension funds there is no value to have a substantial amount of capital to be invested in JGBs at a zero yield,” Takenaka told AsianInvestor. “It is even better to hold cash. Cash yield is of course zero, but JGB yield is currently a negative 0.1 or 0.2, and there is only a risk of further decline.”
Konosuke Kita, director of consulting in Russell Investments’ Japan branch, agreed that the mass diversification away from JGBs is only “natural”.
He further pointed out that asset class's problem and return potential is somewhat “artificially controlled” by the Japanese government.
Although Takenaka sees holding cash as a better strategy than investing in JGBs, he pointed out that some investors are still holding a substantial amount of JGBs. But selling out of them too quickly to radically alter the shift with better-yielding assets is not the answer, he added. The shift to other asset types should instead just happen generically over time.
“Holding these JGBs is a very habitual action, not a rational one. As many Japanese investors are shifting their portfolio from JGBs to riskier and alternatives assets, I consider it a rational shift,” Takenaka said.
“They don’t like quick, radical action so they are not selling their JGBs holdings until the end of their maturity. And then as that naturally happens, they will shift money into other alternatives.”
As the appeal and relevance of JGBs have dwindled, so the adoption of an increasingly flexible asset allocation approach has prompted more Japanese pensions to invest in bonds on a global scale. Today, nearly one in three invest globally both in bonds and equities, the JP Morgan AM survey showed.
Akira Kunikyo, investment specialist at JP Morgan AM, told AsianInvestor that US and Europe are the main destinations for fixed income investments for Japanese corporate pension funds. The appeal of these bond markets’ appeal stem from their size, sophistication and yield potential after foreign currency hedging.
Katsuyuki Tokushima, chief pension adviser at Tokyo-based NLI Research Institute’s pension research centre, told AsianInvestor that alternatives were taking a major share of the capital moving away from JGBs. This trend has continued to prove popular as fixed income yields are not seen rising significantly anytime soon – something underlined by US Treasury bonds and by the Fed’s interest rate cut on July 31, its first since 2008.
“Furthermore, as small equity clashes may happen within this year, the pension funds are not optimistic on global equities either,” Tokushima said.
The survey results show that Japanese pension funds are becoming more focused on assessing overall portfolio risk and considering incorporating more downside protection in the late cycle. Expected returns also continue to inch downwards, with the average target return now reaching 2.28% over the next 10 to 15 years.
“As these institutional investors grow increasingly sophisticated, many are conducting stress testing to assess asset class correlations, model future scenarios, consider relative risk and return characteristics and make portfolios more robust, particularly in the event of a potential economic downturn,” said Kaguya Komatsu, head of Japan institutional business at JP Morgan AM.
“To add diversification and mitigate volatility, they are looking at a variety of strategies, from multi-asset to alternatives.”
Although the overseas investment surge offers potential for both higher returns and better risk diversification, Takenaka pointed out that several pitfalls also lie ahead. For instance, foreign exposure does not shield the pension funds from the next global recession, which the professor with a speciality in international finance believes will happen before the end of 2020.
In that context, the Japanese yen's status as a safe-haven currency could reinforce the pain.
“During the next recession, the yen appreciation will come again, so it will be a damage to Japanese investors’ foreign portfolios. Of course it will depend on their individual hedging relations for foreign exchange but they don’t have 100% hedging,” Takenaka said.
Hence, he believes that the next recession will be somewhat like the one after the Lehman shock in 2008. In the aftermath of the global financial crisis Japanese investors were faced with a very sharp appreciation of the yen, which accentuated their losses.
The corporate pension funds should therefore seek investments with yields where they are also compensated for any necessary hedging costs, Takenaka advised.
* This year's survey polled 113 defined-benefit pension funds and three mutual aid pension funds between March and May of 2019.