## CHAPTER 3 INSTITUTIONAL INVESTORS: FALLING RATES, RISING RISKS ## Source details **Canonical URL:** [CHAPTER 3 INSTITUTIONAL INVESTORS: FALLING RATES, RISING RISKS](https://www.imf.org/-/media/files/publications/gfsr/2019/october/english/ch3.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2019/october/english/ch3.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2019/october/english/ch3.pdf.json) --- ### Key findings - Expected monetary easing has led to a new peak in global bonds outstanding with negative yields. - Institutional investors have increased exposure to illiquid, often highly leveraged alternative investments. - Fixed-income funds lengthened the average effective maturities of their holdings. - Pension funds’ liabilities have increased as yields have declined. - Return guarantees add to insurers’ pressures. ### Fixed-income funds and portfolio similarities - Return correlations between the top and bottom deciles of fixed-income funds have increased as sovereign yields declined, indicating rising similarity in fund strategies. - Fixed-income funds show rising home currency exposures and lower cash positions when yields are low. - With declining interest rates, fund returns became more sensitive to illiquidity factors; average return sensitivity evaluated using 48-month rolling windows increased (series constructed March 2009–March 2019). - Fixed-income funds increased their share in riskier US corporate credit markets as yields fell. ### Pension funds: leverage, illiquid assets, and contingent liquidity - The largest pension funds’ notional derivatives positions rose to 155 percent of net assets, on average, from 95 percent in 2011. - Use of direct on-balance-sheet financial leverage has grown, particularly when net assets are adjusted for illiquid assets. - For a balanced panel of 273 defined-benefit pension funds with about $8 trillion in assets, unfunded obligations are estimated as one-third of alternative investments. - Approximately 20 percent of pension fund assets under management have estimated capital commitments related to alternative investments that are more than half of their liquid assets. - Private capital market activity: Total investor capital calls and capital distributions rose from 2011 to 2018 (2018 = 653; 2011 = 409 for relevant series shown). - Pension funds’ dynamic adjustment of derivative-based hedges can magnify gains when rates fall and contribute to procyclicality when rates move. ### Liquidity stress channels and market procyclicality - Rising portfolio similarities and low cash buffers increase potential for rapid transmission of shocks across investment funds. - Increased holdings of illiquid assets combined with promises of daily liquidity can create pressure to sell into illiquid markets during investor redemptions, amplifying price declines. - Contingent calls from illiquid investments and margin calls on derivatives during stress could force sales or other liquidity-generating actions, reducing funds’ ability to act countercyclically. ### Life insurers: guaranteed returns, duration mismatches, and cross-border allocation - Gaps between guaranteed returns and domestic sovereign bond yields, and duration mismatches between assets and liabilities, remain wide—most notably for some European countries (including Germany) and major Asian insurers. - Asian life insurers (Japan, Korea, Taiwan Province of China) increased foreign assets to nearly $1.5 trillion, almost double the amount five years earlier. - The Asian insurers’ combined share of the US dollar credit market rose to 11 percent from 8 percent over the past five years. - Taiwan Province of China life insurers added $0.25 trillion in new investment in US dollar–denominated credit during 2013–18. - Taiwanese life insurers’ foreign exposures have grown to more than two-thirds of their assets over the past five years. - About one-quarter of Taiwanese insurers’ foreign currency investments are unhedged. - The capital adequacy of Taiwanese insurers is weaker relative to peers, reducing their ability to absorb adverse shocks. ### Increased cross-border allocations by Asian life insurers (detailed) - Low domestic yields have driven a sharp increase in foreign investments by major Asian jurisdictions. - Taiwanese life insurers: - Investment in US dollar credit has risen to more than $400 billion. - This represents 7 percent of all corporate and bank bonds outstanding denominated in US dollars. - Concentration in dollar bonds of non-US issuers: estimated 18 percent of bank debt and 9 percent of corporate bonds. - Hedged yields in figures assume a rolling three-month forward exchange hedge. - The relationship between foreign investment and foreign currency mismatches varies by jurisdiction. ### Vulnerabilities from US dollar exposures and callable bonds - Shock scenarios: - Further declines in US interest rates or a weaker US dollar vis-à-vis the Taiwan dollar could put pressure on Taiwanese life insurers and potentially lead to broader market spillovers. - During global risk aversion, the US dollar is likely to appreciate against the Taiwan dollar, serving as a natural hedge for Taiwanese life insurers (note from source). - Callable bond exposures and interest-rate volatility: - Large holdings of US dollar callable bonds make Taiwanese insurers vulnerable to rate declines because issuers are more likely to redeem bonds early. - Unwinding of hedges when bonds are called could spike interest-rate volatility and induce large losses on unhedged callable bond holdings. - Estimated exposures related to embedded options in US dollar callable bond holdings amount to $300 billion, roughly equivalent to half of the exposures from hedging privately held mortgage-backed securities. ### Liquidity and redemption risks for fixed-income funds - Aggregate and stress estimates: - Total fixed-income funds considered: $10.5 trillion in assets under management. - Estimated total liquidity shortfall: $160 billion (as of March 2019). - Fund-level statistics and dynamics: - Funds with estimated liquidity shortfalls account for almost one-sixth of all fixed-income fund assets and nearly half of all high-yield fund assets. - The average shortfall (as a share of assets of all fixed-income funds) has increased by about one-third over the past two years to about 1.5 percent. - For the assets of funds with liquidity shortfalls, the average shortfall has remained stable at 10 percent. - For a weak tail (one-fifth) of these funds, shortfalls exceed 20 percent of assets. - Larger funds typically face lower redemption stress and tend to hold less cash; diversified portfolios provide more ample liquidity. - Shortfalls of funds in the euro area are higher than those of US-based funds. - Measurement notes: - Liquid assets include cash and assets that can be sold quickly, following the principles of the Basel III standard for high-quality liquid assets (HQLA). - The liquidity stress exercise uses redemption shocks equivalent to the worst percentile of funds’ monthly asset outflows during 2000–19. ### Implications for financial stability - Higher demand for risky assets from institutional investors may further boost asset prices and could encourage more borrowing by nonfinancial firms. - Rising balance-sheet vulnerabilities may force institutional investors to react to shocks in ways that amplify market and macroeconomic impacts. - Cross-border portfolio allocations by insurers and the growing similarity of fund portfolios could propagate shocks across markets and geographies. - Pension funds may need to set aside more liquid assets to cover potential outflows during and after periods of stress, limiting their ability to purchase distressed assets and reducing their countercyclical capacity. - Limited portfolio rebalancing capacity could exacerbate pension fund losses and transmit stress to sponsoring governments and firms by increasing contingent liabilities. ### Policy recommendations to reduce buildup of vulnerabilities - Investment funds: - Introduce minimum eligibility criteria (based on credit quality and liquidity) for the inclusion of assets in fixed-income funds’ portfolios to lessen credit risks and liquidity mismatches. - Require funds to better match redemption periods to the liquidity profiles of their portfolios to mitigate the potential for fire sales. - Enhance guidance for frequent and rigorous stress testing and appropriate disclosures of risks. - Provide appropriate labeling of funds to increase transparency on liquidity risks. - Harmonize standards for the measurement of leverage to help identify and mitigate related vulnerabilities. - Pension funds: - Strengthen regulation, governance, and disclosure to explicitly consider risk from illiquid assets and synthetic leverage. - Require reporting of detailed and standardized calculations of projected liquidity inflows and outflows during periods of stress, and exposure to market risks. - Consider limiting risks associated with guaranteed benefits by adopting cost-sharing arrangements that link a portion of pension payouts to market performance. - Life insurance companies: - Pursue a globally harmonized minimum solvency standard to reduce vulnerabilities and the potential for cross-jurisdiction spillovers through international capital markets. - Implement capital requirements for insurance groups globally to help prevent regulatory arbitrage. - Consider policies that serve as a disincentive to new life insurance products offering guaranteed returns. *Italic: IMF staff; Global Financial Stability Report: Lower for Longer (October 2019), Chapter 3.* ### 1. Market Capitalization and Share of Negative Yielding Global Bonds ### 1. Market Capitalization and Share of Negative Yielding Global Bonds ### Key findings - Expected monetary easing has led to a new peak in global bonds outstanding with negative yields. - Institutional investors have increased exposure to illiquid, often highly leveraged alternative investments. - Fixed-income funds lengthened the average effective maturities of their holdings. - Pension funds’ liabilities have increased as yields have declined. - Return guarantees add to insurers’ pressures. *Sources: Bloomberg Finance L.P.; Haver Analytics; ICE Bond Indices; JPMorgan Chase & Co; Korea Life Insurance Association; Life Insurance Association of Japan; Milliman; Moody’s; Morningstar; SNL Financial; Swiss Re; Taiwan Insurance Institute; US National Association of Insurance Companies; and IMF staff calculations.* ### Fixed-income funds and portfolio similarities - Return correlations between the top and bottom deciles of fixed-income funds have increased as sovereign yields declined, indicating rising similarity in fund strategies. - Fixed-income funds show rising home currency exposures and lower cash positions when yields are low. - With declining interest rates, fund returns became more sensitive to illiquidity factors; average return sensitivity evaluated using 48-month rolling windows increased (series constructed March 2009–March 2019). - Fixed-income funds increased their share in riskier US corporate credit markets as yields fell. ### Pension funds: leverage, illiquid assets, and contingent liquidity - The largest pension funds’ notional derivatives positions rose to 155 percent of net assets, on average, from 95 percent in 2011. - Use of direct on-balance-sheet financial leverage has grown, particularly when net assets are adjusted for illiquid assets. - For a balanced panel of 273 defined-benefit pension funds with about $8 trillion in assets, unfunded obligations are estimated as one-third of alternative investments. - Approximately 20 percent of pension fund assets under management have estimated capital commitments related to alternative investments that are more than half of their liquid assets. - Private capital market activity: Total investor capital calls and capital distributions rose from 2011 to 2018 (2018 = 653; 2011 = 409 for relevant series shown). - Pension funds’ dynamic adjustment of derivative-based hedges can magnify gains when rates fall and contribute to procyclicality when rates move. ### Liquidity stress channels and market procyclicality - Rising portfolio similarities and low cash buffers increase potential for rapid transmission of shocks across investment funds. - Increased holdings of illiquid assets combined with promises of daily liquidity can create pressure to sell into illiquid markets during investor redemptions, amplifying price declines. - Contingent calls from illiquid investments and margin calls on derivatives during stress could force sales or other liquidity-generating actions, reducing funds’ ability to act countercyclically. ### Life insurers: guaranteed returns, duration mismatches, and cross-border allocation - Gaps between guaranteed returns and domestic sovereign bond yields, and duration mismatches between assets and liabilities, remain wide—most notably for some European countries (including Germany) and major Asian insurers. - Asian life insurers (Japan, Korea, Taiwan Province of China) increased foreign assets to nearly $1.5 trillion, almost double the amount five years earlier. - The Asian insurers’ combined share of the US dollar credit market rose to 11 percent from 8 percent over the past five years. - Taiwan Province of China life insurers added $0.25 trillion in new investment in US dollar–denominated credit during 2013–18. - Taiwanese life insurers’ foreign exposures have grown to more than two-thirds of their assets over the past five years. - About one-quarter of Taiwanese insurers’ foreign currency investments are unhedged. - The capital adequacy of Taiwanese insurers is weaker relative to peers, reducing their ability to absorb adverse shocks. ### Implications for financial stability - Higher demand for risky assets from institutional investors may further boost asset prices and could encourage more borrowing by nonfinancial firms. - Rising balance-sheet vulnerabilities may force institutional investors to react to shocks in ways that amplify market and macroeconomic impacts. - Cross-border portfolio allocations by insurers and the growing similarity of fund portfolios could propagate shocks across markets and geographies. - Pension funds may need to set aside more liquid assets to cover potential outflows during and after periods of stress, limiting their ability to purchase distressed assets and reducing their countercyclical capacity. - Limited portfolio rebalancing capacity could exacerbate pension fund losses and transmit stress to sponsoring governments and firms by increasing contingent liabilities. *Sources: Bloomberg Finance L.P.; Haver Analytics; ICE Bond Indices; JPMorgan Chase & Co; Korea Life Insurance Association; Life Insurance Association of Japan; Milliman; Moody’s; Morningstar; SNL Financial; Swiss Re; Taiwan Insurance Institute; US National Association of Insurance Companies; and IMF staff calculations.* ### CHAPTER 3 INSTITUTIONAL INVESTORS: FALLING RATES, RISING RISKS ### CHAPTER 3 INSTITUTIONAL INVESTORS: FALLING RATES, RISING RISKS ### Increased cross-border allocations by Asian life insurers - Low domestic yields have driven a sharp increase in foreign investments by major Asian jurisdictions. - Taiwanese life insurers: - Investment in US dollar credit has risen to more than $400 billion. - This represents 7 percent of all corporate and bank bonds outstanding denominated in US dollars. - Concentration in dollar bonds of non-US issuers: estimated 18 percent of bank debt and 9 percent of corporate bonds. - Hedging and currency exposure: - Life insurer foreign currency exposures are largest for Taiwan Province of China and capital adequacy is weakest there (shareholder equity percent of total assets shown in source figures). - Hedged yields in figures assume a rolling three-month forward exchange hedge. - The relationship between foreign investment and foreign currency mismatches varies by jurisdiction. ### Vulnerabilities from US dollar exposures and callable bonds - Shock scenarios: - Further declines in US interest rates or a weaker US dollar vis-à-vis the Taiwan dollar could put pressure on Taiwanese life insurers and potentially lead to broader market spillovers. - During global risk aversion, the US dollar is likely to appreciate against the Taiwan dollar, serving as a natural hedge for Taiwanese life insurers (note from source). - Callable bond exposures and interest-rate volatility: - Large holdings of US dollar callable bonds make Taiwanese insurers vulnerable to rate declines because issuers are more likely to redeem bonds early. - Unwinding of hedges when bonds are called could spike interest-rate volatility and induce large losses on unhedged callable bond holdings. - Estimated exposures related to embedded options in US dollar callable bond holdings amount to $300 billion, roughly equivalent to half of the exposures from hedging privately held mortgage-backed securities. ### Liquidity and redemption risks for fixed-income funds - Aggregate and stress estimates: - Total fixed-income funds considered: $10.5 trillion in assets under management. - Estimated total liquidity shortfall: $160 billion (as of March 2019). - Fund-level statistics and dynamics: - Funds with estimated liquidity shortfalls account for almost one-sixth of all fixed-income fund assets and nearly half of all high-yield fund assets. - The average shortfall (as a share of assets of all fixed-income funds) has increased by about one-third over the past two years to about 1.5 percent. - For the assets of funds with liquidity shortfalls, the average shortfall has remained stable at 10 percent. - For a weak tail (one-fifth) of these funds, shortfalls exceed 20 percent of assets. - Larger funds typically face lower redemption stress and tend to hold less cash; diversified portfolios provide more ample liquidity. - Shortfalls of funds in the euro area are higher than those of US-based funds. - Measurement notes: - Liquid assets include cash and assets that can be sold quickly, following the principles of the Basel III standard for high-quality liquid assets (HQLA). - The liquidity stress exercise uses redemption shocks equivalent to the worst percentile of funds’ monthly asset outflows during 2000–19. ### Policy recommendations to reduce buildup of vulnerabilities - Investment funds: - Introduce minimum eligibility criteria (based on credit quality and liquidity) for the inclusion of assets in fixed-income funds’ portfolios to lessen credit risks and liquidity mismatches. - Require funds to better match redemption periods to the liquidity profiles of their portfolios to mitigate the potential for fire sales. - Enhance guidance for frequent and rigorous stress testing and appropriate disclosures of risks. - Provide appropriate labeling of funds to increase transparency on liquidity risks. - Harmonize standards for the measurement of leverage to help identify and mitigate related vulnerabilities. - Pension funds: - Strengthen regulation, governance, and disclosure to explicitly consider risk from illiquid assets and synthetic leverage. - Require reporting of detailed and standardized calculations of projected liquidity inflows and outflows during periods of stress, and exposure to market risks. - Consider limiting risks associated with guaranteed benefits by adopting cost-sharing arrangements that link a portion of pension payouts to market performance. - Life insurance companies: - Pursue a globally harmonized minimum solvency standard to reduce vulnerabilities and the potential for cross-jurisdiction spillovers through international capital markets. - Implement capital requirements for insurance groups globally to help prevent regulatory arbitrage. - Consider policies that serve as a disincentive to new life insurance products offering guaranteed returns. *Italic: IMF staff; Global Financial Stability Report: Lower for Longer (October 2019), Chapter 3.* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2019/october/english/ch3.pdf_