By Natsuko Waki
LONDON | Wed Dec 21, 2011 9:32am EST
Article from Reuters
(Reuters) - The euro zone debt crisis may be prompting central bank reserve managers to shift part of their $8 trillion of assets out of sovereign bonds into higher-yielding, real or tangible assets such as property, after years of speculation about such a move.
A plan by China's central bank to create a $300 billion vehicle to invest in Europe and the United States [ID:nL3E7N94W5] highlights many reserve managers' growing impatience with low returns on portfolios heavy with sovereign debt that is seen as increasingly risky.
Central banks, unlike sovereign wealth funds designed to invest in riskier assets, prioritize safety and often forego returns by sticking with relatively low-yielding hard currency assets that earn far less than domestic benchmark investments.
But the 'safety' of many sovereign assets worldwide is now clearly in question. The pool of top-rated triple-A bonds could shrink fast as the euro zone debt crisis deepens and investors doubt whether they are being adequately compensated for risk.
"Asian central banks were thinking of diversifying into real, high-yielding assets even before the crisis, as they increasingly realized the risk of over-concentration in nominal U.S. and euro zone government bonds," said Andrew Rozanov, head of sovereign advisory at Permal.
"The European crisis is a tremendous catalyst for that thinking."
Highlighting the threat to sovereign credit quality, Standard & Poors this month placed 15 euro economies, including top-rated Germany and France, on review for possible downgrade.
Earlier in the year it assigned a negative outlook to the United States' AAA rating, while Moody's warned on Tuesday the euro zone crisis could threaten Britain's top-grade status.
Rating cuts could test FX reserve managers' willingness to continue holding what JP Morgan estimates is around 900 billion euros of triple-A rated European bonds .
Even the euro zone's bailout fund, the European Financial Stability Facility, is struggling to attract investors given the prospect that the six triple-A-rated governments backing it - and on which its own top rating depends - may be downgraded. That would hamper its ability to borrow enough to provide an effective firewall to halt the crisis.
China, Russia and Japan, among other key reserve holders have publicly expressed their reluctance to boost their holdings of EFSF bonds.
"If they are beginning to have serious doubts about a triple-A-rated vehicle guaranteed by all the core euro zone countries (the EFSF), investment in real assets can accelerate," Rozanov said.
NEGATIVE CARRY
Alongside the rising instability in sovereign debt, reserve managers are finding it harder to justify the 'cost of carry' generated when hard currency bought intervening in the forex market is parked in low-yield overseas government bonds.
For example, China's central bank buys U.S. dollars to keep a lid on the yuan exchange rate for export purposes. In doing so, it pumps yuan into its domestic banking system and then needs to sell so-called "sterilisation bonds" to mop up extra yuan that may otherwise stoke inflation.
Assuming like-for-like amounts, the central bank is then losing the difference between what it earns on its accumulated dollars - typically held in U.S. Treasuries - and what it is paying to issue the yuan sterilisation bonds. Right now, that is as much as 200-230 basis points.
"Fundamental carry costs in many of these countries have a real impact. It's very much a negative carry situation," said Cynthia Sweeney Barnes, global head of sovereigns and supranationals at HSBC Global Asset Management.
"It's only so long that can persist. Central banks are effectively managing nations' balance sheets. Eventually you will come to a tipping point where negative carry becomes unsustainable."
Stephen Jen, managing partner at SLJ Macro Partners, estimates it is costing China $130 billion a year in terms of negative carry to maintain its foreign reserves.
"The need to generate higher returns is thus clear."
REAL ASSETS IN EUROPE, U.S.
To date, reserve managers have typically avoided alternative investments that may offer some solution to this loss-making conundrum. But similarly conservative institutional investors, such as pension funds, have increasingly embraced these assets.
And when it comes to assets such as infrastructure and property, Europe and the United States remain top destinations for those funds.
According to Towers Watson, Europe and the United States account for 83 percent of the nearly $1 trillion in alternative assets - including real estate, infrastructure and commodities - held by pension funds. Asia is the destination for just 13 percent of this money.
London and New York property, for example, has been one option and property service provider Knight Frank estimates that prime property prices there have risen 37 percent and 25 percent respectively from the troughs of 2008.
Yields on London commercial property stand at around 3-4 percent, comparing favourably to Treasuries or German bunds.
"It is ... possible that SAFE (China's State Administration of Foreign Exchange) may want to invest directly in European banks, European infrastructure, European automakers, or European properties," Jen said.
Article from Reuters