* Emerging market allure
* Record low bond yields
* FX hedging costs rising
By Jamie McGeever
LONDON, July 22 (Reuters) - Another slide in government bond yields since Britain voted to leave the European Union has put pressure on insurance and pension funds to further reduce their “home bias” and consider riskier overseas assets to recapture returns.
Risk-averse insurers and pension funds typically hold the bulk of their portfolios in domestic securities to shield them from exchange rate and regulatory risks overseas.
That home bias has gradually been reduced over the past 20 years, but the seemingly endless evaporation of domestic bond yields to zero and below in developed economies since the credit crash means there may be further to go.
Although the cost of hedging currency exposure quickly reduces the extra income from higher yields, the damage to long-term returns will only increase the search for alternatives.
“Brexit just exacerbated that longer-term trend. It’s really, really hurting and pressurizing traditional life insurance businesses that offer investment guarantees,” said Bruce Porteous, investment director for insurance solutions at Standard Life in Edinburgh.
The majority of pension and insurance funds’ holdings are held in fixed income assets, mostly in government debt — the lowest-yielding bonds of all.
According to investment bank UBS, the fall in UK gilt yields to new lows after the Brexit vote widened the real yield gap between UK government bonds and company dividends to the highest in more than a quarter of a century.
A 1 percent fall in gilt yields could raise UK firms’ pension liabilities by 150 billion pounds, UBS said, referring to the difference between the total amount due to retirees and the money on hand to make those payments.
The 10-year and 30-year gilt yields hit respective record lows of 0.71 percent and 1.53 percent this month, and both are down 1 percentage point since January.
Pension funds’ allocations to alternative assets - real estate, hedge funds, private equity and commodities - have risen to 24 percent from 5 percent since 1995 across the world’s major markets, according to a study by consultants Willis Towers Watson.
The study also shows that the share of domestic equities in pension portfolios slumped to an average 43 percent last year from 65 percent in 1998. British funds are even lower, more than halving to 35 percent.
As well as FX exposure, higher returns come with higher risk, particularly in emerging markets. Keith Goodby, senior investment consultant in the Insurance Investment Solutions Group at Willis Towers Watson, expects the flow of money overseas to continue at a gradual pace only.
“U.S. fixed income and equities may look quite attractive at the moment given the divergence in yields, particularly post-Brexit. But if you have to hedge the FX risk and swap the rates exposure back to sterling, some of this benefit will be lost,” he said.
Based on existing investments, European insurers can expect annual returns of 2.4 percent, below the 2.7 percent minimum they need, according to a 2015 survey by Standard Life Investments of insurers managing 2.4 trillion euros.
The global scramble for yield has intensified since Britain’s June 23 referendum. Emerging market bond funds have attracted record inflows, Japanese investors have bought record amounts of foreign bonds and an auction of 30-year U.S. Treasury bonds drew record interest from overseas buyers.
Global 10-year bond yields fell to a record low of 0.53 percent in the aftermath of Brexit, according to Citi’s World Global Bond Index, which comprises the benchmark borrowing costs of 23 countries.
Such low rates of return in the usual safer investments has helped fuel a mini-revival of capital flows into emerging markets, according to a report by the Institute for International Finance.
The IIF expects overall net outflows from emerging markets this year to be $350 billion. That’s around $100 billion less than forecast earlier this year, half of last year’s total, and is solely accounted for by outflows from China.
“A feature of the global landscape that will stay with us for months - or years - is the need for investors to be internationally diversified and to pay close attention to international currency risk,” said Michael Metcalfe, head of global macro strategy at State Street Global Markets in London.
“That’s the post-Brexit scenario now - reach for yield and watch your currencies,”
It would be a major shift if UK investors were to join that hunt, especially U.S. bonds. In UK balance of payments data, debt securities investment abroad has averaged close to zero over the past two years, said Nikolaos Panigirtzoglou, managing director for global asset allocation at JP Morgan.
But the rising cost of protecting against exchange rate volatility is tempting some UK funds to dig deeper for returns at home, said Andy Tunningley, head of UK strategic clients at BlackRock, the world’s largest asset manager.
“Net-net, there’s possibly more coming back into the country than leaving. Home bias is actually growing in long-dated illiquid assets with higher yields, like infrastructure and long-lease property,” he said. (Reporting by Jamie McGeever, editing by Larry King)