Sovereigns increase fixed-income allocations amid volatility

Central banks intend to increase renminbi allocations and adopt ESG, survey finds

Sovereign investors, including central banks, increased fixed-income investments and reduced equities in 2018 as returns fell sharply on higher volatility.

This is one of the main findings of Invesco’s global sovereign asset management study. The survey also highlights the increasing attractiveness of Chinese capital markets for these actors, and their rapid adoption of environmental, social and governance (ESG) policies.

“The majority of sovereigns (89%) anticipate the end of the economic cycle within the next two years,” states the survey. “This, combined with volatility concerns and the prospect of negative returns from equities, has led to increased fixed-income allocations and more diversification in allocations to infrastructure, real estate and private equity markets.” 

The survey was conducted in early 2019 in face-to-face interviews with 139 individual sovereign investors and central bank reserve managers who collectively oversee $20.3 trillion of assets. Overall, 71 central banks took part in the exercise.

“What we are seeing is a move to defend and diversify portfolios,” Alex Millar, head of Europe, Middle East and Africa institutional distribution sales at Invesco, tells Central Banking. “In previous years we had seen a continuous decline in fixed-income allocations, but this year we have seen a notable jump in fixed income.”

Fixed income allocations increased to 33% in 2019, up from 30%, becoming sovereigns’ largest asset class according to the survey. Meanwhile, allocations to equities fell from 33% to 30%.

In the low-yield post-crisis environment, sovereign investors had increased their equity exposures to boost returns. But volatility sharply reduced returns for participants in the survey in 2018. On average, returns fell to just 4% in 2018 compared with 9% in 2017.

Pivot to Asia

In spite of this shift towards safer assets, sovereign investors appear more inclined to expand their exposure to new markets, to the detriment of some advanced economies.

“Sovereigns reported an increased interest in emerging markets generally, and China specifically, at the cost of Europe,” says Millar. Slower growth and perceived rising political risk in major European economies are the main reasons for this, says the study.

In this environment, nearly 33% of participants decreased their allocations to Europe in 2018, and a similar number intends to do the same in 2019. Only 13% of participants said they plan to increase allocations to the continent this year, compared with 40% that aim to do so in Asia, and 36% in emerging markets.

Another factor modifying official investments in Europe is the low-yield environment. “Central banks continue to diversify away from the negative yields of government bonds (especially in Europe) into bank deposits; and away from the US dollar,” says the survey. “The main beneficiary has been the renminbi.”

In 2017–18, the renminbi overtook the Australian and Canadian dollar in international reserves portfolios. Now, 43% of central banks participating in the survey hold the renminbi, compared with 40% in 2018. And over a quarter – 27% – of central banks say they expect to continue to increase renminbi reserves in 2019.

Trade tensions

Geopolitical risks, specifically trade tensions, feature prominently in sovereign investors’ thinking, according to the survey. Some 82% of participants cited trade tensions as having had an influence on asset-allocation decisions.

“What is interesting is that although US-China trade tensions were the main risk mentioned by official investors, they report China is the main area they are pivoting to,” says Millar.

“It’s a long-term strategy. Sovereigns are aware of the risks; they are also staffing up their teams and resources,” Millar adds. “They’ve got Chinese speakers, people who understand the environment. They’re strategically looking to increase their allocations to China.”

This trend may be fostered by China’s recent inclusion in major bond benchmarks, such as Barclays Global Aggregate Index and Bond Connect. This is likely to facilitate foreign investors’ access to the local bond market, says the survey.

For those already invested in China, transparency remains an obstacle to higher allocations in the country, reports the survey. For those sovereigns with no investments in China, investment restrictions and currency risk are seen as the main hurdles.

ESG adoption

ESG is an increasingly important issue for sovereigns and central banks. Since 2017, the percentage of survey participants with a specific ESG policy rose from 46% to 60%. Now, 20% of central banks have an ESG policy, compared with just 11% in 2017.

“We looked at this two years ago, and we found a binary situation among sovereign funds,” says Invesco’s executive. “The Western funds, Canadians, Europeans, Australasians were focused on environmental, social and governance back then, and believed quite strongly in it. They had the ability to either add returns or significantly help with risk.”

However, the other part of the sovereign community were much more cautious, and demanded more data and evidence. They weren’t sure how relevant it was to them, or how it fitted with their mandates.

“What it comes through is the pace of change within two years,” says Millar. “Far more funds have now ESG policies, even those who were unsure how it impacted them only a couple of years ago. They are much more aware of the social context they are in, and that is feeding through into central banks.”

Within ESG, the focus is currently on environmental policies, says Millar. “It is providing some sort of opportunities for them in, for instance, alternative energy as an investment opportunity.” 

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