Gulf Sovereign Wealth Funds Rethink Fixed Income as Fed Raises Rates
Posted on 06/19/2022
As Gulf sovereign wealth funds refill their coffers from the rising global price of oil, the influx of cash appears to be finding new homes in new issuances of debt in a world of rising interest rates. Sovereign funds like the Abu Dhabi Investment Authority (ADIA), Qatar Investment Authority (QIA), and to an extent on the central bank front the Saudi Central Bank have complained about the challenges of finding yield in a low interest rate world. SWFI estimates ADIA has around US$ 100 billion allocated to sovereign debt, while Norway Government Pension Fund Global has around US$ 250 billion plus in that bucket. These long term institutional investors are active in the world of sovereign debt, eyeing so-called century bond issuances. The pendulum is now swinging in the other direction, as Western governments have lost the ability to control inflation partially caused by monetary policy mismatches, stoking inflation to levels unseen in decades. U.S. inflation accelerated to 8.6% in May 2022, a shocking 40-year high. The figure prompted the Federal Reserve to have its largest interest rate increase since 1994.
U.S. Treasury Secretary Janet Yellen said that “unacceptably high” prices are likely to stick with consumers through 2022 on the T.V. show ABC’s This Week on June 19, 2022. “We’ve had high inflation so far this year, and that locks in higher inflation for the rest of the year,” she said Sunday on ABC’s “This Week.”
“I expect the economy to slow,” she said, adding: “But I don’t think a recession at all inevitable.”
Forcing SWFs to Embrace Higher Portfolio Risk and Century Bonds
Cash-rich Gulf-based sovereign wealth funds fared better performance-wise in the 2000s, 2010s, and part of the 2020s in allocating capital to equity and illiquid markets such as private equity, private credit, infrastructure, and to an extent real estate in some cases. Norway Government Pension Fund Global ended up having more than 70% of its massive portfolio in listed equities, growing frustrated with finding suitable fixed income investments to generate return. The accelerated QE policies of the Bank of Japan, European Central Bank, Federal Reserve, and other European central banks provided these various government the ability to have essentially “free money”. The sovereign debt at low-to-zero interest rates, sometimes negative interest rates, at the time, allowed these governments to spend and accrue debt to try to catalyze their respective economies. Some sovereign funds adapted by allocating more toward alternatives and listed stocks, and entering riskier areas of the bond spectrum, such as emerging market debt and private credit. The decades-long maturities of some of these government bonds made the price of the securities highly sensitive to interest rates. This clearly was a lure for institutional fixed income buyers because as interest rates slid, the gains were larger. This is now swinging in the opposite direction, as holders of low interest rate securities are feeling the pain, as new bonds are being issued with higher interest rates.
Sovereign wealth funds who over-allocated to long duration fixed income holdings are now seeing the value of their bonds decrease, as higher-yielding government debt are being issued. Remember century bonds? Century bonds were heavily marketed by Wall Street and other European banks. In March 2016, Ireland issued a century bond at a coupon of 2.35% through a private placement by Goldman Sachs and Nomura. During 2011, at a high point in the eurozone debt crisis, Ireland’s 10-year bonds were at the 15% level. In 2017, J.P. Morgan helped Oxford University enter the capital markets for the first time in its 800-year history with the sale of a US$ 1 billion century bond. Companies such as The Walt Disney Company and Coca-Cola have issued 100-year notes, and even sovereign governments that have defaulted like Argentina have issued century bonds. J.P. Morgan led the sale of a 100-year bond for Austria in 2019 as yields across the globe drop to record lows at the time. A good deal for Austria as it was able to tap the market for ultra-long-term debt, looking to take advantage of low interest rates. Austria first issued a 100-year bond in 2017, raising €3.5 billion and paying investors a coupon of 2.1%. Pensions, sovereign funds, and insurance companies were heavily pitched during the low-interest rate environment that long-dated debt is attractive because it could be matched to long-term liabilities. Hedge funds and other riskier fixed income investors could also make gains through currency or interest rate swap trades. The European Central Bank helped create the environment of negative interest rate bonds and century bonds on the continent, as the ECB upped the pace of its bond purchases over the decade.
Fast-forward to 2022 as many bonds from highly-rated borrowers with long-terms plummeted. The price of the University of Oxford’s debt due in 2117 – the century bond – dropped 49% year-to-date. Austria, which was highly-rated by the rating agencies, saw its 2120 (century bond) bond price fall to around 63%. Sovereign investors in the Middle East are rethinking fixed income asset allocation; should they wait it out? This is a plausible question for many investment committees.