The Icelandic market has been severely hit by the financial crisis this past year. What changes have Icelandic pension funds made to their asset allocation?

The trend has been to move back into fixed income. In 1996, Icelandic pension funds had almost zero allocation to equities. They only invested in fixed income – mainly government bonds. Since then, there’s been a slow growth in their equity exposure. About a year ago, most funds had increased their equity allocation to about 40 per cent of assets. But since July last year, the exposure to equities has decreased. Some may have sold a bit, but it’s mainly due to the drop in market value. Therefore, the fixed income allocations have increased and the steady flow of assets into the pension fund system has also gone into fixed income over the past 12 months.

Which asset classes are you most optimistic about?

We have been quite optimistic about the outlook of government bonds and we still are. The inflation-linked government bonds have been a great investment and my opinion is that these investments are the best in Iceland right now. For the last one-and-a-half years, we have been increasing the allocation to these kinds of bonds in all our portfolios. The real yields are 4.2 per cent plus inflation on the longest ones and inflation has been 15 per cent, so returns from these bonds have been excellent. Pension funds’ liabilities are linked to inflation, which makes these investments very suitable. However, some think that inflation is going down quite dramatically. I’m not as confident as others and am a little bit afraid that it might be quite difficult to get the inflation down.

So why not invest all your money into government bonds?

Government bonds are already the biggest asset class. While the typical European pension fund has not been investing much in inflation-linked bonds, Icelandic funds allocate almost 40 per cent. But the market is simply not big enough. The pension fund system is actually bigger than the government bond market. The value of the pension funds are IKr1,800bn (€13.17bn) and the government bond market is about IKr800bn. The pension funds are also growing much faster than the supply of inflation-linked bonds.

Are Icelandic government bonds interesting for foreign investors too?

There has been some interest from foreign investors and I believe that now is a great time for foreigners to invest, since the Icelandic krona is quite weak. In 2002 and 2003, there was huge interest from abroad for these kinds of bonds. The performance was great for them because the krona was appreciating and the yields of bonds were going down – so they had capital gains. I think the situation now is quite similar and I believe that we are in the early stages of foreign investments into these bonds.

Which asset classes are you most cautious about and where are the biggest risks?

We’re most cautious about equities, both Icelandic and foreign. I’m not saying that equities are too expensive – in fact, the prices are much better now than a year ago. We simply like fixed income better and risk adjusted; we like government bonds the best. We’ve also been very cautious about the corporate bond market, because we felt the credit spreads were too thin. We’ve been buying almost none of these bonds for the past two years.

In the short run, we also have the currency risk. The Icelandic krona is just way too small. In fact, there are more people using the Piccadilly line in the London tube every day than people using the Icelandic krona.

Do you think keeping the Icelandic krona is sustainable?

I think there’s almost 0 per cent chance of still having the krona in 10 years, but that’s just my personal opinion. I think that the existence of the Icelandic krona and whether or not we should join the euro will be the biggest debate here for the next few years. It’s very difficult for investors and businesses here to plan anything if you have this huge fluctuation of the currency.

The depreciation of the currency has also affected investments abroad. Has currency hedging been a mistake?

There is no easy answer to that. Over the long term, I believe that you should seriously considering hedging some of your currency risk. The short-term fluctuations have been so dramatic over the past six months and hedging the currency has led to lower performance, so of course it would have been better not to hedge. In our portfolios, we’re using active currency hedging and we were almost unhedged in the beginning of this year.

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