Posted by: Dirk | March 3, 2014

Finance 101: How much of its assets should a public pension fund invest in bonds?

The FT carries an article today by Takatoshi Ito, who chaired a panel of experts, on sovereign debt holdings of Japanese pension fonds:

How much of its assets should a public pension fund invest in bonds? Consider the question assuming that bond yields in developed economies remain low for a few more years, but are expected to rise, the economy is expected to go back to a growth path and the inflation rate is expected to rise from a deflationary level to a normal 2 per cent in a year or two.

Ito goes on to call this Finance 101. Here is his answer:

There is a widespread belief in Japan, shared by some in the GPIF, that government bonds are “safe” and stocks are risky, and that bonds are for pension funds and stocks for speculators.

Fifteen years of deflation and the 25-year decline of the Nikkei 225 index have reinforced this belief. There is insufficient consideration of the interest rate risk of long-dated bonds and the benefits of diversifying into a variety of asset classes.

The panel members unanimously agreed that the GPIF bond portfolio is exposed to too much risk from an expected rise in interest rates, a natural consequence of Prime Minister Shinzo Abe’s economic programme and Bank of Japan governor Haruhiko Kuroda’s 2 per cent inflation targeting.

I disagree with his view. First of all, the widespread belief that Japanese government bonds are safe is based on the fact that they are, well, safe! The way the monetary system works in Japan, the government can always approach the central bank and get fresh reserves in return for government bonds (either directly or indirectly). So the probability of default is zero, unlike in the euro area where the central bank does not directly finance the governments.

Now about the fact that when bond prices are very high, so that effective yields are basically zero, the yields can only go up, which means prices can only go down. We heard this for many years now. However, if you hold bonds that pay you zero interest and you hold them to maturity – which is something which a pension fund will probably do – then you will not have lost any money, although the valuation of the bond will have decreased after the interest rates rose (even though I cannot see any reason to do that in Japan, which is far, far away from an inflationary spiral). You just did not make more money than you could have made if – and that is a big if – the interest rates have started to rise. So, if pension funds won’t buy as many sovereign bonds as in the past, will interest rates in Japan go up? Not if the central bank controls the interest rate and buys up any excess sovereign bonds to keep it that way.



  1. The only answer is ZERO. Public pension funds are not supposed to have any funds in them so there sould nothing be invested.
    Public pension funds are designed to be only a pass trough, to deliver portion of income/production from present workers to retirees
    Public pensions are social contracts where present workers give a part of the income/production to the retirees and then when present workers retire, they will receive part of the future worker’s income/production. And money is only a way to account such distribution of production and services.That is called Social Contract.
    If all money taken from present workers is not spent, but saved, then economy will suffer.
    Paradox of thrift points to savings as strugling an economy. And also spending= income.
    If there are savings in public pensions, then that will make less income in an economy and economy will suffer which will make future income for those workers in retirement be less then if economy is in top shape.
    Or the future generation will have to first work on improvement and developement in order to gat economy in tip top shape before they can give their retirees properly.

    Public pension is supposed to be spent imediately.

    • Public pensions, and maybe any pension, also have recourse to assets created in the past and drawn on by people in the present. Schools, hospitals, roads, private factories etc etc. The economy and government is forward looking, it must be – a thing that the current distorted view conveniently forgets. History tells us that we must be consuming things now created in the past. People who work create productive assets. Governments spend on oublic asset – including health, welfare and education. It’s a process of cyclical renewal. Keynes understood this. Read Randall Wray on pensions.

      • We are not in contradiction. You are talking about usage of real assets i am talking about way to make it happen. Spending money is not same as using real assets, as you indicated, but enabling the creation of future ones. Full Demand creates more capacity, not only using it. If money is saved in pension funds, there will be less then full demand.
        To create those real assets you are talking about we have to spend money which i am talking about.
        In other words:
        If we do not spend money imediately but save it, then next generation will have to build their assets/capacity first before sharring it with us. By spending pension funds imediately, we are creating those assets/capacity before next generation takes over
        I read Wray, and there si no contradiction with what i said. He is giving explanations why is intergenerational solidarity a neccessery thing.

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