Gulf sovereign wealth funds rethink fixed income as Fed hikes rates
Published on 06/19/2022
As Gulf sovereign wealth funds fill their coffers thanks to the rising global oil price, the influx of liquidity appears to be finding new homes in new debt issuances in a world of rising interest rates. Sovereign wealth funds like the Abu Dhabi Investment Authority (ADIA), the Qatar Investment Authority (QIA) and, to some extent, on the central bank front, the Central Bank of Saudi Arabia have complained about the difficulties in finding returns in a world of low interest rates. SWFI estimates that ADIA has about US$100 billion allocated to sovereign debt, while the Norway Government Pension Fund Global has about US$250 billion and more in this tranche. These long-term institutional investors are active in the world of sovereign debt, eyeing the so-called bond issues of the century. The pendulum is now swinging the other way as Western governments have lost the ability to control inflation in part due to monetary policy inadequacies, fueling inflation to levels not seen in decades. US inflation accelerated to 8.6% in May 2022, a shocking 40-year high. The figure prompted the Federal Reserve to have its biggest interest rate hike since 1994.
US Treasury Secretary Janet Yellen said “unacceptably high” prices are likely to stay with consumers through 2022 on ABC’s This Week TV show on June 19, 2022. “We’ve had high inflation until this year, and that’s inflation for the rest of the year,” she said on ABC’s “This Week” Sunday.
“I expect the economy to slow down,” she said, adding, “But I don’t think a recession is inevitable at all.”
Forcing Sovereign Wealth Funds to Adopt Higher Portfolio Risk and Century Bonds
Cash-rich sovereign wealth funds based in the Gulf achieved better performance results in the 2000s, 2010s and part of the 2020s by allocating capital to equity and illiquid markets such as private equity, private credit , infrastructure and, to some extent, real estate in some cases. Norway Government Pension Fund Global ended up having more than 70% of its massive portfolio in listed stocks, growing increasingly frustrated with finding suitable fixed income investments to generate a return. The accelerated quantitative easing policies of the Bank of Japan, the European Central Bank, the Federal Reserve and other European central banks have given these various governments the opportunity to essentially have “free money”. Sovereign debt at interest rates ranging from low to zero, sometimes at negative interest rates, at the time allowed these governments to spend and go into debt to try to catalyze their respective economies. Some sovereign wealth funds have adapted by allocating more to alternatives and listed equities, 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 have made the price of the securities very sensitive to interest rates. This was clearly a lure for institutional fixed income buyers, as as interest rates fell, the gains were greater. It is now going in the opposite direction as holders of low interest rate securities are feeling the pain as new bonds are issued with higher interest rates.
Sovereign wealth funds that have over-allocated to long-dated fixed-income securities are now seeing the value of their bonds decline, as higher-yielding government debt is issued. Do you remember the bonds of the century? Century bonds were heavily traded by Wall Street and other European banks. In March 2016, Ireland issued a century bond at a coupon of 2.35% via a private placement by Goldman Sachs and Nomura. In 2011, at a peak of the Eurozone debt crisis, Ireland’s 10-year bonds were at the 15% level. In 2017, JP 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 centenary bond. Companies like The Walt Disney Company and Coca-Cola have issued 100-year notes, and even defaulting sovereign governments like Argentina have issued centennial bonds. JP Morgan led the sale of a 100-year bond for Austria in 2019 as yields across the world fell to record lows at the time. A good deal for Austria as it was able to tap into the very long-term debt market, seeking 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 wealth funds and insurance companies have been strongly touted during the low interest rate environment that long-term debt is attractive as it could be matched with long-term liabilities. Hedge funds and other riskier bond investors could also make gains through currency or interest rate swaps. The European Central Bank helped create an environment of negative interest rate bonds and century bonds on the continent, as the ECB accelerated the pace of its bond purchases over the decade.
Fast forward to 2022, as many bonds from well-rated long-term borrowers have fallen. The price of Oxford University’s debt due in 2117 – the bond of the century – has fallen 49% since the start of the year. Austria, which was highly rated by rating agencies, saw its 2120 bond price (bond of the century) drop to around 63%. Middle Eastern Sovereign Investors Rethink Bond Asset Allocation; should they wait? This is a plausible question for many investment committees.