* Aussie pension funds struggle to find assets
* Risky CLOs and PIK notes return as funds hunt yield
* Changes to contribution levels means problem will worsen
By Cecile Lefort
SYDNEY, April 4 Australian pension funds are
investing in riskier assets to overcome an embarrassment of
riches - they have too much money and too few investment
This not entirely unwelcome problem is the result of
Australia's mandatory pension contribution pension system, which
is now worth A$1.5 trillion ($1.38 trillion).
That is a huge amount for an economy the size of Australia's
- it is as large as the country's annual economic output and
larger than its entire stock market capitalisation.
Australia has an ageing population so fund managers are
under considerable pressure to find investments that will fund a
comfortable retirement - especially when last year's
industry-wide rate of return was 15 percent.
"It's inevitable," said Chris Selby, head of private wealth
management at Deutsche Bank. "There aren't enough instruments at
home generating yields to satisfy the need of a growing
population of retirees."
More than half of the pension pool is invested in stocks and
about a third is already overseas so there is limited scope to
seek yields there without throwing portfolios out of balance.
About 22 percent of pension fund assets is allocated to
fixed income. Australian government bonds offer some of the
world's highest and safest returns, but investors are willing to
take more risk to boost their funds' performance.
Australia's 10-year AAA bonds pay 4.1 percent, compared with
a mere 3.6 percent offered by Spain's euro-denominated debt
rated some nine notches lower at BBB-minus.
Even though Australia plans to sell more debt in future to
fund a deteriorating budget position, its bonds are well-bid and
tightly-held by offshore central banks and sovereign funds.
With term deposits paying around 4.5 percent, it is not
surprising that fund managers allocate 8 percent of their assets
This situation is tempting investors to move back into
assets that have been anathema since the global financial crisis
struck in 2008. These include global banks offering around
complex debt instruments such as collateralised loan
obligations, or CLOs, to Australian investors. CLOs are
securities cobbled together from pools of corporate loans.
Other risky instruments include PIK (payment-in-kind)
securities. Typically, PIK notes allow the borrower not to pay
the cash interest coupon but to issue another note to cover
unpaid interest - in other words by issuing more debt.
Earlier this month, a subsidiary of Australia-based mining
logistics company Bis Industries sold a US$250 million 5-year
PIK note with an eye-watering yield of 12.4 percent or 1086
basis points over U.S. government bonds, data from IFR shows.
Standard & Poor's, which rated the issue CCC-plus, said
investors have a less than a 10 percent chance of recovering
their money in the event of default.
Bob Sahota, head of fixed income at Challenger Limited
, said he had considered investing in PIK notes but saw
more attractive relative value in more senior parts of the
PIK structures were quite popular before the financial
crisis and highly-leveraged companies often used them.
The shortage of high-yielding investments is deeply felt in
Australia, in part because there is no sub-investment grade bond
Not helping is the reluctance of the nation's fund
management community to finance infrastructure projects due to a
natural preference for accumulation rather than income. The
local pension system is based on defined contributions versus
defined benefits such as in Canada, where pension funds pay
retirees a proportion of final salary.
Another factor that aggravates the hunt for yield is a
competitive banking environment where lenders are ready to offer
cheap loans - undermining the development of a deep and liquid
corporate bond market that could attract pension fund
Deutsche Bank and Royal Bank of Scotland are arranging a
U.S.$6 billion five-year loan for A-plus rated mining giant BHP
Billiton at just 20 basis points (bps) over the
benchmark rate. This is far below the circa 100 basis points at
which banks typically borrow.
"People say it's different this time, and it's true that we
are much less leveraged than in 2006 but there are plenty of red
flags," said a fixed-income fund manager.
He said the return of PIK notes, rising mispricing of credit
and looser covenants could lead to another debt blow-up.
(Reporting by Cecile Lefort; Editing by Eric Meijer)