RISING RATES TAKE SOME SHINE OFF PRIVATE MARKETS / THE WALL STREET JOURNAL

Rising Rates Take Some Shine Off Private Markets

Higher-yielding bonds lure public pension funds that loaded up on alternative assets

By Heather Gillers

After years of shifting money into private market investments, public pension and investment funds are taking a fresh look at publicly traded debt, thanks to the highest yields in more than a decade.

“Bonds are back,” said California State Teachers’ Retirement System investment chief Christopher Ailman. 

He predicted that public pension funds will shift an additional 2% to 5% of assets into publicly traded debt, reversing a multidecade trend of shrinking fixed-income portfolios.  

Bonds are a hot topic among the state and local investment managers who control around $5 trillion in public workers’ retirement savings and other government money. 

The investment chief of Alaska’s $77 billion state fund said in February he wants to cancel a plan to reduce bonds and add private equity. 

An adviser to the $447 billion California Public Employees’ Retirement System urged board members to consider the amount that stocks are projected to return relative to less-risky bonds, a gap that has been shrinking.

The $72.5 billion Los Angeles County Employees Retirement Association currently aims to keep 45% of its money in alternative investments such as private equity and real estate, almost a third in stocks and less than a fifth in bonds, in an effort to meet its return target. 

Discussions this year about how to allocate assets could get “very interesting,” investment chief Jonathan Grabel told the board, thanks to the sharp rise over the past year in short-term Treasury yields.

“If we’re trying to get 7% and you can earn 5% in a two-year note, that really changes everything,” Mr. Grabel said.

The California Public Employees’ Retirement System had all of its money in bonds until the late 1960s. / PHOTO: MAX WHITTAKER/REUTERS

The decision-making is being upended by the same force that helped fuel the run on a handful of U.S. regional banks in March and has whipsawed stock markets: the sharp rise in interest rates in response to the post-Covid inflation surge. 

For decades, publicly traded debt was a mainstay of pension funds, providing safe, dependable, long-term income. 

Calpers had all of its money in bonds until 1967. 

After staying above about 7% for most of the 1970s and 1980s, 10-year Treasury yields slid significantly starting in 2000. 

Retirement officials came to view investment-grade bonds as similar to cash: a drag on returns that came in handy if markets fell. 

Major public pension funds’ holdings of bonds and cash fell to 23% in 2022 from 33% in 2001, according to an analysis by the Boston College Center for Retirement Research. 

One pension fund’s investment staff joked that the fixed-income department had become the “no-income department.” 

After years of insufficiently funded benefit promises and losses in the 2000-02 dot-com bust and the 2008 financial crisis, public pension funds were banking on returns of 6% or more to cover future benefits. 

To meet those targets, the funds piled into private equity as well as hedge funds, infrastructure, real estate and private debt, helping fuel the growth of managers including Blackstone Inc. and Apollo Global Management Inc. 

Alternative investments rose to 34% of pension assets in 2022 from 9.2% in 2001, according to Boston College. 

To be sure, those alternative-asset portfolios are likely to remain robust. 

A survey of private-equity investors by the data provider Preqin found that while fewer are planning to increase their commitments in 2023 than in 2022, most intend to keep their level of investment steady in the long term. 

“An overwhelming majority of pension funds choose to invest in private equity year after year,” said Drew Maloney, chief executive officer of the American Investment Council, a trade group for private equity. 

As recent events have shown, rising yields are apt to draw funds from all over the financial world. 

Sheila Ryan, a managing director at the investment consultant Cambridge Associates, said retirement funds are reducing allocations to stocks, hedge funds and private market investments such as private equity to increase their bond portfolios. 

She said some are also gravitating to private credit investments, such as loans to businesses, whose interest payments rise and fall with prevailing rates. 

At the investment consultant Wilshire, Tom Toth, a managing director, said he is watching clients who previously shifted money out of bonds think through whether they can now meet their investment targets while taking on less risk. 

He told Calpers board members on March 13 that the expected return on their fixed-income portfolio is almost 5%, up from 2% last year.

The additional return that stocks can earn above less-risky bonds has shrunk, Mr. Toth said. 

“This is an important point for investors as they think about portfolio construction and risk-taking in an uncertain environment,” he said.

At Alaska Permanent Fund Corp., which invests oil revenue and other state money, investment chief Marcus Frampton wants to cancel a plan to trim the fixed-income portfolio to 18% from 20%, as well as a plan to increase private equity to 19% from 17%.

Greg Allen, CEO at the investment consultant Callan, mapped out how the math has changed at a February meeting of the Alaska fund’s board. 

In 2022, “you had to have a complicated illiquid portfolio with no bonds to make 7%,” Mr. Allen said. 

Now “you can actually have a third of your portfolio in fixed income and still make 7%.”