Insight

Sovereign wealth funds look to fixed income and private markets

Sovereign wealth funds look to fixed income and private markets

In traditional portfolio construction, the "three-factor framework" examines growth, defensive, and inflation characteristics as core drivers of return and risk. For nearly four decades, growth (e.g., equities) and defensive (e.g., core bonds) factors were remarkably successful globally due to a strong economic backdrop and structurally declining rates. Along with low to moderate inflation during this period, "inflation-sensitive" assets didn't experience much success, except for relatively short periods (e.g., the oil price spike in the mid-to-late 2000s). It is necessary to look back to the 70s to find a period where the inflation factor worked consistently.

Now that inflation has become a more persistent issue again, with 86% of respondents in Invesco’s latest 2023 Global Sovereign Asset Management Study (IGSAMS) believing inflation will remain elevated versus recent historical norms over the next two years, this is serving as a substantial driver in asset allocation decisions for sovereign wealth funds (SWFs).  As we’ll examine below, this has meaningfully transformed the global opportunity set and investor intentions.

Figure 1 – Expectations for inflation in developed markets in the next 2 years (% citations, total sample)

Source: IGSAMS 2023. Question: What is the more likely scenario for inflation over the next two years in developed markets? Sample size: 132.

The increase in rates has created an interesting entry point for both public and private fixed income across the quality spectrum. Looking at our Long-term Capital Market Assumptions, a global 60/40 portfolio has an expected return of 6.2% over the next 10 years, just 18 months ago this figure was 4.5%. This lion’s share of the increased return expectations has come from core fixed income, driven by the increasing rate environment. Another asset class within fixed income that we find particularly interesting from a risk-return perspective is emerging market debt, which has an expected 10-year return of 7.3% with an identical level of expected volatility. So, while investors tend to think about higher rates and the second-order impacts through a very short-term lens, we expect this to actually benefit strategic investors over the next market cycle. 

We also believe that the growth of private markets will continue to serve as both a source of enhanced returns and a means to mitigate volatility for SWFs. When considering the credit aspect of private markets, it is important to highlight that a significant portion of this exposure consists of floating-rate investments, which can provide benefits to investors from an inflation-mitigation standpoint.

From our on-the-ground discussions with SWFs, we have essentially seen private market interest fall into two distinct camps – emerging SWF players who are beginning to increase their base allocations to private markets from somewhat low levels (e.g., emerging Southeast Asia) and experienced private markets investors looking to refine and add value through a more granular approach (e.g., Middle East and developed Asia Pacific). For emerging SWF players, the key is to appropriately integrate private markets into a public portfolio that achieves and actually increases the probability of meeting core investment outcomes. These discussions are very asset-allocation-driven and understanding the appropriate way to fund these private markets allocations is critical. For experienced investors, their needs revolve around customized solutions as well as secondary and co-investment opportunities. This is a space we believe will grow considerably over the next several years. 

The findings of the IGSAMS study corroborate our views. Fixed income allocations by sovereign wealth funds in the study have slightly rebounded after two years of decline and make up 28% of the overall AUM of the sample of funds surveyed. SWFs also had the highest net intention levels to allocate to fixed income at 28% of the sample.1 Looking specifically at emerging market debt, 74% of investors sampled currently invest in this asset class, the highest proportion among the different types of alternative fixed income (Figure 3). Respondents are particularly looking to new sources of diversification and higher returns across emerging Asia, Latin America, and Africa. 

Figure 2 - Net allocation intentions by year (Intentions to increase – intentions to decrease) (% citations, SWFs only)

Source: IGSAMS, 2023. Question: For each asset class, do you intend on increasing/maintaining/decreasing your strategic asset allocation (SAA) over the next 12 months? Sample size: 77.

Investors surveyed have also continued to increase allocations to alternative investments, which now stand at 27% (excluding direct strategic investments), with the increase driven by a steady rise in illiquid alternatives. When asked about the types of alternative fixed income that investors find most attractive to invest in now, the top choice for SWFs was direct lending/private credit.  Additionally, SWFs are seeking opportunities to harvest the inflation factor through investments in alternative asset classes such as infrastructure, with 25% of respondents expressing net allocation intentions.

Figure 3 - Types of alternative fixed income invested in (% citations, SWFs only)

Source: IGSAMS, 2023. Questions: Which of the following types of fixed income do you invest in? Sample size: 53. 

About Invesco’s 2023 Global Sovereign Asset Management Study

Running since 2013, this year marks the eleventh year of the Invesco Global Sovereign Asset Management Study and represents the views and opinions of 142 chief investment officers, heads of asset classes and senior portfolio strategists at 85 sovereign wealth funds and 57 central banks. Collectively, these institutions manage approximately US$21 trillion in assets (as of March 2023). The fieldwork for this study was conducted by NMG between January and March 2023.

Footnotes

  • 1

    Net allocation = Intentions to increase – intentions to decrease 

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