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INVESTMENT FOCUS-Loyal friends may save bond markets from carnage

Natsuko Waki
Friday, 29 Nov 2013 | 8:01 AM ET

LONDON, Nov 29 (Reuters) - The 30-year bond boom looks to be over but fears of a dramatic sell-off next year may be overstated.

Even if the U.S. Federal Reserve terminates its entire bond buying progamme by the end of 2014, growing long-term demand from pension and insurance funds and a gradual reduction in government borrowing are likely to cushion the impact.

Structural changes such as ageing populations and tougher regulatory requirements are instead attracting investors at a time when budget deficits around the world are finally falling.

The Fed is expected to at least start reducing its $85 billion of monthly bond purchases next year. Assuming it stops the whole programme by September, bond buying by the G4 central banks would be cut by some $500 billion to $1.08 trillion in 2014, according to JP Morgan.

On top of that, private sector bond demand overall is expected to shrink too. The investment bank expects total global bond buying to fall by as much as $750 billion to $1.5 trillion.

On the face of it, that's a scary prospect for bond markets - but there are significant buffers in place.

Pension funds and insurers, which manage assets of around $55 trillion globally, continue to herd into fixed income regardless of bond market performance.

Currently they buy about $430 billion of bonds a year. But as yields rise, in a somewhat contrarian manner, they may be tempted to buy more to lock in their investments at a more favourable interest rate.

"It's not obvious there should be a quick and dramatic sell-off in government bonds given there's underlying demand. So many people including pension funds and insurers are sitting on the short end, financially repressed," said Andreas Utermann, chief investment officer at Allianz Global Investors.

"If you keep short rates very low there's only that steep the yield curve can get before it becomes too attractive for insurance and pension companies given their liabilities to invest again."

Pension funds are struggling to boost assets in a low-yielding climate to a level sufficient to pay future retirees. Those with chronic funding deficits are keen to shift investment in favour of bonds to match their bond-like liabilities.

"For the majority of them rising yields offer the opportunity to reduce a duration mismatch by having more bonds. You lock in a higher rate and you effectively reduce the gap between the duration of assets and liabilities," said Nikolaos Panigirtzoglou, managing director at JP Morgan.

According to Mercer, European pension funds who manage assets of more than 2.5 billion euros boosted bond allocation to 55 percent this year from 50 percent in 2012, at the expense of equities which fell to 23 percent from 24 percent.

And this is a long-term trend. In Britain for example, bond allocation has risen to 47 percent from 31 percent a decade ago.

"They can be helped by rising yields because the cost of funding liabilities goes down. But the capital value of existing investments also goes down," said David Hanratty, head of global strategic partners at Pioneer Investments.

"If you protect your fixed income investment base from the effect of rising yields, you get a win-win. You will have a substantial compression in deficits if you have the right fixed income strategy."

IMPROVING FISCAL BOOKS

On the supply side, the sale of new bonds is expected to decline by $600 billion next year to $1.8 trillion, driven by the fall in the government sector of $350 billion.

This is largely because government spending cuts are narrowing fiscal deficits. Paris-based OECD projects average public deficits of its member countries will improve to 3.8 percent next year from 4.3 percent this year.

Excess supply, or the balance between supply and demand, is expected to rise to $280 billion from $140 billion this year, but this gap would be significantly higher if it were not for the reduction in government debt issuance or indeed the persistent demand from the big institutional funds.

"If supply was not shrinking, the gap between supply and demand will be in order of $600 billion. So it's a lot smaller," Panigirtzoglou at JP Morgan said.

(Editing by Susan Fenton)