April 4, 2014 / 1:47 AM / 4 years ago

Embarrassment of riches drives Australia funds to embrace high risk

* 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 (Reuters) - Australian pension funds are investing in riskier assets to overcome an embarrassment of riches - they have too much money and too few investment opportunities.

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 to cash.

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 capital structure.

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 market.

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 investment.

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)

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