By John Parry - Analysis
NEW YORK (Reuters) - Reeling from the plunges in stock markets, insurers and pension funds are paring back their holdings of equities and adding highly rated debt, including corporate bonds.
Chastened by the brutal effects of the biggest financial crisis since the 1930s, investors of all stripes -- from these long-term buy side institutions to retail investors -- have dramatically lowered expectations for investment returns.
While U.S. stock prices have fallen by about half from their heady peaks of late 2007, government-issued Treasury bonds have rallied in the past two years because of their comparative safety amid the financial turmoil. Prices for corporate bonds, after hitting extreme lows late last year amid the economic recession, have rebounded on some optimism about government economic rescue measures.
In the seismically altered economic landscape, long-term investors see higher-rated corporates and government bonds as safer bets.
"We have particularly increased investment grade corporate bonds and government bonds," said Andrew Milligan, head of global strategy at Edinburgh-based Standard Life Investments. The life insurer's wealth management arm manages assets of about $180 billion, of which some $75 billion is in fixed income.
This year, global investment grade corporate bonds could return about 6 percent while government bonds may return about 3 percent, Milligan expects.
"At the moment our view would be people should be happy with (that) yield," Milligan said, even though such returns are a far cry from the returns the stock market generated earlier this decade.
"Any capital gains should be seen as added benefit: cherry on the cake," he said, adding that bonds had risks of their own. Corporate bonds could be hit by ratings downgrades in a painful global recession, while government bond prices ultimately could be dragged lower by a huge tide of issuance.
Milligan reckons that stocks will continue to outperform government debt by about three percentage points a year -- the so-called "equity premium" -- which might justify keeping weightings in equities similar to before the global financial crisis erupted in mid-2007.
Yet Milligan and others say pension funds, life insurers and mutual funds are showing renewed interest in holding high-grade corporate bonds.
"People will be buying debt instead of equity in companies that they like," said Jim Blinn, president of Securities Quote Xchange, a pricing service for fixed income securities based in Aurora, Illinois.
Fund management company Federated Investors for instance took a "significant overweight" position in high yield and investment grade corporate bonds in the fourth quarter and said it increased its overall recommended allocation to bonds earlier this month.
"Once the market realizes a lot of corporations are going to survive, they will go after the debt first and then after the equity of these companies. Over the next six months, you will see some confidence come back into the bond market," Blinn said.
That's a bold prediction, given the precarious state of many companies as the biggest debt bubble in living memory bursts. In riskier "junk" or high-yield U.S. corporate bonds, rating agency Moody's Investors Service has forecast the global junk bond default rate may peak at more than 15 percent late this year, roughly matching levels in the 1930s.
For corporate bonds that are investment grade, the danger of rating downgrades remains high for industrial flagships such as General Electric, (GE.N) as S&P's removal of its coveted "AAA" rating this week underscores.
Even so, pension funds' growing emphasis on both government and highly rated corporate debt, a trend for more than a decade, is likely to accelerate, said Milligan.
In Britain, pension schemes "increasingly need exposure to credit," especially longer maturity corporate bonds "and much less of a weighting to the equity risk premium," said Milligan. "That trend is obviously accelerated by a bear market and will be in place for the foreseeable future," he added.
Still, some point out that equities holdings will pay off in the much longer term.
Since 1870 the Standard & Poor's Composite, now known as the S&P 500, has returned an annual average 8.3 percent through March 2009, beating the 10-year U.S. government note's return of about 5 percent and corporate bonds' returns of about 6 percent, said Bryan Taylor, chief economist with Global Financial Data in Los Angeles.
"If pension funds are looking out over the next two to three years, buying more fixed income would be a good strategy, but if they are looking 20 or 30 years out they are doing the wrong thing because equities will beat bonds," Taylor said.
(Reporting by John Parry; Editing by Chizu Nomiyama)
