Washington, DC, March 5, 2015 - Investors have been confronted with a fundamental "asset-liability mismatch", owing to low interest rates and a shortage of high quality assets, according to the Institute of International Finance's latest' Capital Markets Monitor.
"Globally, institutional investors have boosted their holdings of corporate and foreign bonds by 65 percent since 2008 to $5.1 trillion, including a record level of $2.1 trillion of high-yield bonds," said Hung Tran, executive managing director at the IIF. "This strategy has produced good returns in recent years as rates declined and credit spreads narrowed.' However, investors may find it difficult to rebalance their portfolios away from credit risk as market liquidity has deteriorated greatly in recent years."
The IIF noted that a sustained period of low rates means that a lower discount rate is being used to calculate the present value of long-term pension liabilities, boosting these values.' This has contributed to the underfunding of public and corporate pension funds, as their current assets fail to match the present value of their liabilities. As a result, the shortfall will require a large increase in contributions from sponsors--which may in turn put pressure on many fiscally-stretched government entities, particularly at the local level.
The IIF also cited concern that secondary corporate bond market liquidity has added to the allure of bond exchange traded funds (ETFs) which have received fast growing net inflows in recent years, exceeding $60 billion in 2014 and accelerating so far this year. A growing number of institutions have purchased ETFs attracted by the perceived liquidity of these instruments.' However, the IIF warned that ETF liquidity depends on the existence of plentiful buyer and sellers at any moment in time.
The IIF also noted that carry trades have been one of the most important ways to increase the degree of leverage used to generate extra return.' In this scenario, an investor borrows in a low interest rate foreign currency and invests in a higher-yielding domestic or foreign asset, taking on FX risk in the process.
The IIF said that the longer lower rates and net negative supply of high-quality government bonds persists, the more pressure is put on long-term investors to take on extra risk to generate income. The IIF warned that these risks could accumulate and render the financial system more fragile as long players become more exposed to a severe market downturn.
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The Institute of International Finance is the global association for the financial industry, with close to 500 members from 70 countries. Its mission is to support the financial industry in the prudent management of risks; to develop sound industry practices; and to advocate for regulatory, financial and economic policies that are in the broad interests of its members and foster global financial stability and sustainable economic growth. Within its membership IIF counts commercial and investment banks, asset managers, insurance companies, sovereign wealth funds, hedge funds, central banks and development banks. For more information visit' www.iif.com.