Roundtable. Alternative Fixed Income. Break-out Role. Fixed income is ready to play a new part in Canadian pension portfolios

Transcription

1 Alternative Fixed Income Roundtable Break-out Role Fixed income is ready to play a new part in Canadian pension portfolios When it comes to fixed income, can Canadian plan sponsors have it all extra yield, liability hedging and diversification? The answer to that question is a resounding yes for many plans, but it does depend how far down the road they are when it comes to embracing the changing bond universe. Indeed, fixed income is now playing a vastly different role in many pension portfolios than it has in the past. As that happens more and more, Canadian plan sponsors are beginning to realize that the fixed income status quo isn t going to be enough to meet their goals, especially with rising rates on the horizon and equity market volatility to contend with. Experts at the 2015 Alternative Fixed Income Roundtable explored the changing bond space and what it means for pension funds. What are the biggest challenges plan sponsors currently face, and what tools and strategies are emerging to help them manage their portfolios better for the long term? From private debt to global credit to absolute return fixed income, today s fixed income portfolios are looking at lot different than they did just a few years ago. In this report, we cover what those changes look like and some of the reasons why plan sponsors are retooling their approach to bonds.

2 Expert Panel: Senior Portfolio Manager, Fixed Income AB Managing Director and Portfolio Manager, Private Fixed Income Sun Life Investment Management Inc. Managing Director, Canada Institutions AB Chief Operating Officer Sun Life Investment Management Inc. Vice-President, Institutional Advisory Group - Fixed Income CIBC Asset Management Inc. Partner and Associate Director, Fixed Income Product Management Wellington Management Company, LLP Managing Director, Business Development Manager Wellington Management Company, LLP Managing Director, Head of Global Fixed Income CIBC Asset Management Inc. 2 Sponsored Supplement Alternative Fixed Income

3 How has fixed income investment changed for pension investors over the last decade? Fixed income remains a source of capital preservation, income generation and liquidity, and a match for liabilities that hasn t changed much in 10 years. However, the bond market has changed dramatically: today, bond yields remain at record lows, despite a genuine improvement in the U.S. economy. That has had costly implications for pension funds. As that has happened, the fixed income marketplace has grown there are now a greater number of issuers creating a more diverse market than we had a decade ago. More companies have turned to the bond market for their financing needs, and equity market volatility has led to greater demand for fixed income to offset portfolio risk, prompting a flight to quality. And let s not forget the rise of emerging markets debt, as many issuers were upgraded over this time. One big change is that plan sponsors are now matching their assets and liabilities more carefully using fixed income. There has also been an increase in plans doing liability-driven investing (LDI), which is driving demand for long bonds. Another, more important change has been the dramatic decline in interest rates. Even a decade ago, 10-year rates in Canada were at about 5%. Now they re below 2%. As a result, investors are now looking for other alternatives to increase yield. In the past, the role of fixed income was homogeneous it was a diversifier for equities, and a source of liquidity. Today, it s all over the map. Fixed income has evolved into what equities were at the beginning of the 1990s. Some plans are going global in their core portfolio, and others are using a core portfolio in Canadian bonds and building satellite portfolios around it. Low yields have been a primary driver of changes in pension portfolios for the last five years, at least. That If plan sponsors are using fixed income to generate returns, then, obviously, falling yields generate higher short-term returns. But it also makes achieving return objectives more challenging in the long term. has created a significant appetite among plan sponsors for alternative fixed income approaches, like unconstrained and absolute return strategies, for example. What s the biggest fixed income challenge plan sponsors will face in the future? The big challenge going forward is demographics, as the peak of the baby boom hits the traditional retirement age. Retiring baby boomers will shift the emphasis of investment management to income generating assets. Plan sponsors will need sufficient and reliable cash flows to meet the needs of retiring members, and they will need good quality, long-term assets to match their liabilities. For some, this will mean taking on less liquid assets in exchange for enhanced yield, especially as rates remain low. I think the challenge with fixed income depends on each plan sponsor s objective. If plan sponsors are using fixed Alternative Fixed Income Sponsored Supplement 3

4 The diversification point that Nushi mentioned really resonates with me. If you re thinking about extending the duration, then Canadian-only fixed income portfolios are very concentrated. The investment universe is about half provincials, with two-thirds Ontario and Québec. However, there are ways to diversify into new assets private credit, for example, or other markets. Plan sponsors could also look at building portfolios with exposure to multiple countries, and expand outside the Canadian long duration market. Unfortunately, I think Canadian pension plans are just waking up to the idea that they need to be matching their assets and liabilities better. income to generate returns, then, obviously, falling yields generate higher short-term returns. But it also makes achieving return objectives more challenging in the long term. For these investors, adding more active risk within their fixed income allocation can help improve upon the low returns provided by the market. But, should returns be the objective for a pension plan or should they be matching the liabilities of the plan? If matching liabilities is the objective, then rising rates aren t the biggest risk in fact, rising rates are good for underfunded plans. The real risk for most plans seeking to meet their liabilities is falling yields, which inflate the present value of their future obligations. You re absolutely right. Unfortunately, I think Canadian pension plans are just waking up to the idea that they need to be matching their assets and liabilities better. Plan sponsors have to balance both: they need additional excess yield, especially in this environment, where yields are so low. Liability matching will protect them in the long run, but they also require diversification. Maybe that s the challenge: figuring out what the role of fixed income should be in the portfolio. Clearly, as Wendy mentioned, plan sponsors need to be thinking about the role fixed income should play but what can they do to address some of the challenges and realities in the fixed income space today? I think plan sponsors need to change their mindset. A lot of pension plans are still worrying about asset performance, and comparing that to peers. But, those peers may have very different liabilities. Plan sponsors need to focus on what their liabilities are relative to their objectives. Whether it s minimizing the funding gap or reducing surplus volatility. Mark-to-market volatility on the asset side is less important. I think plan sponsors have responded to low yields by chasing additional returns. But, as Michael says, we have to remember what a pension porfolio is trying to accomplish: meeting long-term obligations. I do think plan sponsors need to rethink the role fixed income plays in their portfolios. Some plans have done this by separating assets into two portfolios with distinct objectives: a risk-mitigating portfolio, focused on achieving the beta they are seeking, and a growth portfolio that is focused on enhancing overall returns. Another way to broaden fixed income use is in the risk- Historically, yields were high enough for Canadian pension plans to be invested primarily in Canadian public fixed income. But now, as they look forward with interest rates expected to stay low they have to think about new strategies. 4 Sponsored Supplement Alternative Fixed Income

5 Many kinds of alternative fixed income offer good returns that compete well with growth categories like equities and alternatives but with less volatility. mitigating portfolio through a core plus approach that gives plan sponsors opportunistic access to different types of bonds, while managing portfolios against beta risk. Over the last decade, questions have arisen about the sustainability of DB plans on a go-forward basis particularly corporate plans. As a result, we re seeing tremendous interest in group annuities from companies that want to get out of the pension plan business entirely. These plans are generally waiting for higher interest rates before they move they want to get a better quote on the annuity. LDI is also a way that many plans are addressing sustainability issues, especially as funding ratios move closer to 100%. If you talked to somebody in 2008 about LDI or in 2009 about LDI, given where funding ratios were, it would have been a non-starter today, the conversations are shifting. Plans are also moving towards a beta that matches their liabilities but, depending on the maturity of the plan, that s likely to be an imprecise match. That s where alpha comes in. It s a lot more challenging today to generate alpha, especially in Canadian fixed income that has spurred this movement in Canada to more alternative fixed income types. But not all alternatives are created equal. You have various beta strategies distressed debt, mezzanine and high yield strategies. And, they have a different risk return profile. If a strategy is new for pension plans, they have to stand back and see how it acts over a long period of time, and over a few cycles. You are taking more risk with some of these strategies plan sponsors don t necessarily want to take on more risk to get additional alpha. One way the large institutional investors have addressed that problem is by getting out of fixed income and going to real assets, like real estate and infrastructure, as a proxy. However, liquidity is also a risk. That s one of the things that augurs well for private fixed income in Canada there s no illusion of liquidity. If you buy private assets, you are holding them to maturity. In exchange, you get a significant liquidity premium and regular cash flows. The risk is that, by substituting direct infrastructure or real estate investments as an alternative for bonds, you could lose the diversification benefits that fixed income has traditionally offered relative to equities. These investments are more highly correlated with economic growth and the equity markets. At the same time, there are very few asset classes that provide diversification against potential deflation. By substituting fixed income for these alternative types of income producing assets, you won t get the diversification that government bonds provide. The diversification point is key, which is why a lot of plan sponsors are opting for a core plus approach where alternative fixed income can be added, opportunistically, Most plans, if they look deeply across their asset classes, will realize there are opportunities to reduce some of that excess liquidity in exchange for higher returns. Alternative Fixed Income Sponsored Supplement 5

6 common thread is that each step moves a pension plan a bit further away from some static benchmark, even if that benchmark is your liability. Each step allows them to add a bit of return potential while maintaining their desired risk profile. The goal is to improve that riskreward relationship, which is the underlying challenge of the whole exercise. For many plan sponsors, core plus might be their first step to global fixed income that s a key part of the evolution. to enhance returns and improve portfolio diversification all while managing to the traditional Canadian fixed income benchmarks. I do think it s important that a core plus portfolio maintain a strong Canadian base. Plan sponsors should, instead, consider adding more fixed income alternatives on the growth-oriented side of their portfolios. Many kinds of alternative fixed income offer good returns that compete well with growth categories like equities and alternatives but with less volatility. Let s talk about alternative fixed income what strategies are plan sponsors looking to in order to manage their fixed income portfolios in these challenging times? Alternative fixed income options include global credit, high yield, emerging market debt, leveraged loan, private debt and unconstrained bond strategies. It s a wide-ranging set of strategies, and every one fits differently into a pension portfolio. Which one a plan sponsor chooses really depends on what their starting point is. For a client that s starting with a passive core or long core portfolio, to think of going into an unconstrained absolute return strategy might be too big of a step. But, they could move from a passive to an active portfolio, or they could move to core plus and incorporate non-canadian bonds. I think the Alternative fixed income is not so much an asset class as a diverse collection of strategies, but to determine which one is appropriate to your needs you must figure out what your liquidity requirements are, what your return objective is and whether the strategy can realistically meet that objective in the future. You have to do very careful due diligence on alternative strategies, even if they have longer track records, because the last five years have been a particular market and economic environment. Strategies that worked particularly well over the last five years may not do so in the future. Looking at the market today, investors could benefit from strategies where exposure to rates is actively managed in a wide range, and from all-weather strategies that are not expected to have systematic exposure to major risk factors, including duration. This discussion has already touched on some of them, but what are the risks in using alternative fixed income? Alternative fixed income should be thought of as a secondary strategy to the primary Canadian fixed income strategy. But, a particular alternative approach might not address the traditional fixed income needs of the plan liquidity and liability matching. There are other risks. If the returns of the alternative strategy are positively correlated with the returns of the primary fixed income strategy, the alternative strategy will not improve the diversification benefits of a fixed income portfolio. There s also default risk, transparency issues and, depending on which country you re dealing with, possible political risk, regulatory risk and currency risk. Currency volatility can overwhelm fixed income returns very easily, so many plans want it hedged. And, in a lower yielding enviroment, there is less carry to make up for the currency volatility. Liquidity risk is one of the things plan sponsors want to talk about in a lot of detail. The reality for midsized pension plans in Canada today is that more than 80% of their fixed income allocations are tied to public bond indices that in theory could be liquidated very, very quickly. Plans willing to move some of their public fixed income allocation to Canadian private fixed income will need to give up some liquidity but it s in exchange for a liquidity premium and better returns. Most plans, if they look deeply across their 6 Sponsored Supplement Alternative Fixed Income

7 asset classes, will realize there are opportunities to reduce some of that excess liquidity in exchange for higher returns. Valuation is a big deal, and also benchmarking: some of these strategies are new, so there are not as many direct comparables. For example, there are many core plus strategies out there and they re not all made the same yet, they tend to be compared together using the same benchmarks. Unlike most public and traditional investments, you don t typically have full transparency around the types of strategies being pursued or the holdings, and that can make due diligence much more challenging. Even if there s a long track record, it can be difficult to evaluate because the data isn t always reliable. For instance, what type of pricing and valuation discipline are they applying? We haven t used the term de-risking very much today. But, when we say de-risking, we think we re talking about fixed income and we re actually talking about equities. This conversation reminds me of the 1990s: we worked so hard back then to get equities right, and all we had to do was sit there with 100% fixed income and we would have done well. Are we doing the opposite now, trying to get fixed income right should we focus more on with equities? What about government bonds what role should they play? I think they still play an important role, and in an environment where yields are low and spreads are somewhat tight, the best thing to do is to just diversify and have a mix of rate risk and credit risk. Rate risk remains important but I think one of the trends we see is a lot of movement towards credit risk at the expense of rate risk. That said, why do we need to keep all the rate risk in Canada? There are other Absolute return fixed income...can help provide a diversifying return profile relative to traditional fixed income markets. These portfolios will be better equipped to navigate a rising rate environment, if or when we get there. opportunities out there, particularly after hedging for currency risk. You can get some pretty attractive yields outside of the Canadian universe, so why not globalize your rate risk? Even if you re matching your liabilities, global rates actually tend to track each other relatively closely they generally rally together and sell off a bit more idiosyncratically. And so, if you can diversify across different rate regimes, you d potentially end up with better risk-adjusted returns. North American bond yields are actually quite high right now compared to many developed markets; and, in a well-constructed and diversified portfolio, there will always be a role for government bonds. If there s one thing we learned from the equity market sell-off in recent years, you can t neglect the security and reliability of government bonds, especially high-quality Canadian ones. The Government of Canada remains one of the last AAA-rated issuers. Both federal and provincial Canadian bonds provide a strong alignment with the liabilities and interest-rate sensitivities of pension plans. That s what allows plan sponsors to sleep at night. Alternative Fixed Income Sponsored Supplement 7

8 Absolute return strategies lack a correlation with liabilities, which is why they should be used to provide growth, rather than mitigate risk. These strategies could replace equities or other alternatives for plans looking to de-risk and eventually lower risk in the overall portfolio. They are lower volatility but they also deliver lower returns relative to other growth assets, like stocks. So, as plans improve their funded status and start lowering their return expectations and focusing on volatility, low-risk alpha strategies like these will likely become more attractive. The reality is, within many global strategies, most of the currency exposure is hedged back to Canadian dollars. Some think that currency hedging is expensive, but that s simply not true. Government bonds have traditionally been used for duration adjustment [and] liquidity needs, and as collateral for any derivative strategies. But at such historical low yields, the opportunity cost of holding these bonds has never been higher. What role can absolute return in fixed income play in a pension portfolio? Absolute return fixed income has been an area of interest and activity over the last several years, but plan sponsors should dedicate significant time to the evaluation process. What are the holdings, and do they have a systematic market bias? Plan sponsors also need to expand their sensitivity analysis not just to the rates markets, but also to the credit markets. This can ensure they re not substituting one form of risk for another while believing that they re getting something they re not. But, when it s successful, absolute return fixed income can help provide a diversifying return profile relative to traditional fixed income markets. These portfolios will be better equipped to navigate a rising rate environment, if or when we get there. Its impact could be exacerbated for many investors, given the extending duration of many traditional fixed income benchmarks. What about the growing global bond space? How has this evolved, and how are plan sponsors using these products? Global fixed income is the largest asset class in the world, and yet, according to a recent Greenwich Associates survey, the percentage of Canadian institutional investors with a dedicated allocation was just 3%. Global fixed income is available to Canadian institutions to help them diversify their rate and credit risk exposure and there is more they could do. For many plan sponsors, core plus might be their first step to global fixed income that s a key part of the evolution. I agree that we are seeing more take-up in a core plus approach, where managers can allocate opportunistically in the global credit space. It s really a first step, and where it s being used right now. Erin spoke earlier about the case for diversifying rate risk globally through global bonds. Canadian plans could also take a portion of their exposure to the Canadian corporate bond market (which is very thin and very concentrated in financials and energy) and allocate that to a global credit portfolio. The global corporate bond market is 19 times the size of the Canadian corporate bond market. They can get valuable diversification there. Global bonds are certainly a way to diversify, but, on the alternative private debt side, the largest opportunity set is outside of Canada. People like to get niche-oriented when they step into the more aggressive markets like a dedicated emerging markets portfolio. Maybe it s local currency, maybe it s hard currency. But it can be argued that, just as a global and multisector approach works well for core bond portfolios, global and multi-sector portfolios can also be more effective in the higher-octane fixed income markets. 8 Sponsored Supplement Alternative Fixed Income

9 Does the shift to alternative fixed income present any governance challenges for plan sponsors? What about education? These fixed income categories do present governance challenges. Most use non-traditional asset classes, as well as derivatives. Some strategies might use leverage, so additional monitoring is needed. Plan sponsors need to understand the risk controls in place and, depending on the expertise of the plan s board, there might be an additional educational ramp-up required to understand how alternative fixed income strategies work and what the risks are. And, in some cases, derivatives are just not allowed. For those plans, it s impossible to consider a whole number of strategies. Epsecially those using leverage: that is a no-go for many plans. Leverage can be used to manage risk, but headlines have showed us how it can hurt. Coming out of 2008, there s still a stigma about the use of derivatives. But, the reality is, derivatives such as credit default swaps were actually more liquid during the crisis than physical bonds were. Derivatives can be an important liquidity management tool. Retiring baby boomers will shift the emphasis of investment management to income generating assets. Plan sponsors will need sufficient and reliable cash flows to meet the needs of retiring members, and they will need good quality, long-term assets to match their liabilities. Fees are a big issue. If someone s invested passively to start with, it s a big jump to justify the increasing fees in active alternative fixed income. That s one issue, but the biggest question I get is around currency. Everyone assumes if you re going to alternative fixed income and global fixed income, you obviously have non-canadian currency exposures but your liabilities are in Canadian dollars. The reality is, within many global strategies, most of the currency exposure is hedged back to Canadian dollars. Some think that currency hedging is expensive, but that s simply not true. That s a really good point. We get questions about currency hedging too because, obviously, everything has to be swapped back to Canadian dollars. So what is the cost? And I say, listen, it s relative: we might have to pay ten basis points, even twenty basis points, which is huge in the fixed income world. But, if a bond manager is providing three hundred basis points of excess yield, that s just irrelevant. Are Canadian plan sponsors ready for alternative fixed income and, if so, where does it fit in a pension portfolio? Frustration with low yields and concerns around interestrate risk and inflation volatility continues to be top of mind for plan sponsors. So, I think the momentum is definitely there. However, the decision process is slower for all the reasons we ve been discussing. Plan sponsors do need to get more comfortable with derivatives. They need to gain comfort with different and often unfamiliar segments of the fixed income market whether private or public. I do think plan sponsors are there, but really understanding where it belongs in a portfolio is critical. It belongs on the risk mitigating side of a pension portfolio, but only in a very controlled manner. Core plus is a good example of this. Adding it on the growth side requires a greater commitment to monitoring, in order to ensure that crosscorrelations among asset classes aren t positive. And board education will be key. Alternative Fixed Income Sponsored Supplement 9

10 Sponsored by: AllianceBernstein (AB) is one of the world s largest investment management firms, with over $474 billion in assets under management as of December 31, Their global client base includes some of the world s leading institutions as well as private clients and retail investors. The firm manages assets for clients through separate accounts and commingled vehicles, both on a direct and sub-advised basis. AB has been in the investment management business for more than 40 years, and they remain singularly focused on asset management and research today. AB has embraced a deep commitment to comprehensive and superior research, with 200+ in-house analysts. The breadth of their research expertise is reflected in the range of investment solutions they offer, which span asset classes and regions as well as the risk-return spectrum: traditional and unconstrained fixed income, style-pure and absolute return-focused equities, index funds and structured services, multi-asset-class solutions, and alternatives. In addition, they have created and manage one of the largest custom target-date platforms in the US; they were the first in the industry to offer guaranteed lifetime income services for plan sponsors. Sun Life Investment Management Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and commodity trading manager. We specialize in providing private asset class pooled funds particularly in private fixed income, commercial mortgages and real estate and liability driven strategies for defined benefit pension plans and other institutional investors in Canada. Through our affiliation with Sun Life Assurance Company of Canada, we leverage the expertise of over 200 investment professionals who manage over $110 billion in assets for the Sun Life Financial group of companies as of December 31, This gives Sun Life Investment Management Inc. a range of capabilities unmatched by traditional asset managers. We cater to the specialized needs of institutional investors by providing alternative investments and customized investment solutions, drawing on the knowledge and experience of a leading financial services organization. CIBC Asset Management (CAM), the asset management subsidiary of CIBC, provides a range of high-quality investment management services and solutions to individual and institutional investors. CAM s offerings include: a comprehensive platform of mutual funds, strategic managed portfolio solutions, discretionary high-net-worth investment management services, and institutional portfolio management. CAM is one of Canada s largest asset management firms, with over $100 billion in assets under management as of October 31, Wellington Management is an investment adviser to more than 2,100 institutions in over 50 countries. Our mission as a firm is simple: to exceed the investment objectives and service expectations of our clients worldwide. With US$914 billion in client assets under management, we offer a broad range of equity, fixed income, alternative, and multi-asset investment approaches. We are a globally integrated community of investment professionals. Our most distinctive strength is our rigorous, proprietary research, which is shared collaboratively across all areas of the organization. We have offices in the US, Europe, Asia, and Australia. (Figures as of 31 December 2014.) 10 Sponsored Supplement Alternative Fixed Income