With Interest Rates Low, US Pension Funds Make Risky Investments In Emerging Market Debt

Recently, China announced that it would sell its first negative-yielding bond at an effective interest rate of negative 0.15 percent. This is the first country, other than those in the Organization for Economic Co-operation and Development (OCED), to sell a negative-yielding bond, becoming part of a global trend towards tumbling interest rates as the COVID-19 pandemic continues and central governments around the world take on more debt.

In the United States, public pension funds, which have an average investment return target of 7.25 percent, will likely struggle to meet those investment targets and could be severely impacted by plummeting interest rates. Without changes to pension plans’ assumed rates of return, many public pension systems will see an increase in debt.

Unfortunately, many public pension plan managers are not interested in adjusting their investment return targets to realistic levels at this time. Instead, they are seeking riskier, potentially higher-yielding investments in an effort to make up for depressed interest rates and hit their targets.

Fixed-income investments, like government and corporate bonds, have been a part of pension fund portfolios for decades. And, for several pension funds, fixed-income investments hover around 25 percent of their entire investment portfolios.

New Mexico’s Educational Retirement Board (ERB), which serves the state’s teachers, is one such plan that dedicates roughly a quarter of its portfolio to fixed-income assets. Within New Mexico ERB’s fixed income-investment allocation, 7 percent of funds go to emerging market debt, which is essentially sovereign bonds issued by countries classified by the World Bank as lower-to-middle-income to upper-middle-income. This includes countries such as Brazil, India, and Nigeria.

Even though emerging market debt carries much higher yields that are attractive to pension funds, those benefits can be outweighed by enormous risks since several of these countries have defaulted on their debt in the past. Due to this risk, public pension investment allocations to emerging market debt have historically been used sparingly in pension fund portfolios. However, in recent months, pension fund managers have signaled a growing appetite for allocating more assets to this asset class. The reasons for this change could be:

1. Smaller Contraction and Sharper Rebound – According to the International Monetary Fund (IMF), the developed world’s economy will, on average, contract about 5.8 percent in 2020 and rebound about 3.9 percent in 2021. Those numbers are almost reversed for the emerging markets where the economic contraction is expected to be about 3.3 percent in 2020 with a rebound of 6 percent in 2021. This means that on average, the emerging markets are forecast to be a key driver of economic growth post-pandemic.
2. Search for Yield – With the downward pressure on interest rates in the US, Europe, China, and elsewhere, the search for higher yields will be paramount for pension funds seeking to hit their investment return targets without lowering investment return assumptions.
3. Backstop from IMF – Given the risk of debt defaults as discussed earlier, emerging market investment was always severely limited in pension funds. With the coronavirus pandemic continuing, the IMF has provided partial guarantees to several emerging markets in debt relief. This response has made this debt much more attractive.

There are still a lot of risks associated with emerging market debt. For starters, each of the economic forecasts and scenarios above may not materialize fully. For example, the economic rebound may not be as strong as expected, or the IMF may not guarantee as much debt as investors expect. Each of these scenarios would be a blow to the attractiveness of emerging market debt.

On top of that, these emerging market countries have significant currency risks that could be made worse through recent trends in declining exports. In other words, many public pension funds are still taking significant financial gambles by investing in emerging market debt.

As long as public pension funds across the country continue to maintain unrealistically high annual return targets of around 7.25 percent, and as long interest rates in developed economies continue to plummet to zero—and below zero, we can expect emerging market debt to continue to gain traction with plans willing to take significant risks in 2021 and beyond.