Fixed income is known for its portfolio-hedging properties and global sovereign debt presents opportunities for investors—yet pension funds are sometimes nervous when it comes to this asset class.
“Long‐term bonds are the best hedge against pension liabilities,” said Marlene Puffer, president of Twist Financial Corp., speaking at Benefits Canada’s annual Benefits & Pension Summit in Toronto. Despite that, there is little fixed income in pension portfolios and the duration is much shorter than the duration of the liabilities because the low-yield environment makes it challenging to think about fixed income, Puffer added.
“One of the barriers has been that everybody has perceived that rates are [too] low” to put in a liability-driven strategy; but investors that implemented long-bond strategies years ago did very well, she explained. “If you think rates can’t go lower, think again. It’s entirely possible that long rates do drop further, in which case you need to worry about your exposure.”
While long bonds offer the best hedge for liabilities, leverage and derivatives can mitigate the opportunity cost of hedging and allow larger returns, Puffer explained.
“Leveraging and derivatives—provided that they’re used with a mind to their hedging properties—don’t really pose a risk,” she said. “There’s a fine line between using derivatives for speculative purposes versus for hedging.”
But, she added, investors have to be careful about how they write their mandates for their money managers in terms of what instruments they allow and how risk should be monitored. “Don’t just look at the weights you have in various sectors. Write a mandate, which includes a proper measure of the risk profile.”
Global debt
When looking for long bonds, investors should consider some European countries, said Puffer. “Yields in Spain were over 7% over the crisis. At that time, it was tough to see light at the end of the tunnel.” But today, Spanish 10-year yields are not that different from Canadian or U.S. ones, she noted. “If you are brave enough to go into global fixed income, you can capture lots of spread.”
That sentiment was echoed by John Welch, executive director and emerging market macro strategist with CIBC World Markets, who spoke at the same conference. “If you’re looking for spread, there are some good candidates—if you can stomach the risk,” he said. Those countries include emerging markets such as Argentina and Venezuela, whose spreads are at distress levels. But Welch said he sees no possibility of default with sovereign debt.
Despite the opportunities, investors have been fearful. Emerging markets produce more than 50% of global GDP, but “right now investors are still very underinvested” in emerging market debt, Welch added.
What will happen to interest rates?
Most central banks in the world remain accommodative due to subdued inflation, but this has already started to ebb with the tapering in the U.S., noted Welch. The European Central Bank still has a tight policy but is considering easing, he added.
“[World] interest rates will rise at some point, but well into the next decade, low rates are expected,” Welch said.
All the articles from the event can be found on our special section: 2014 Benefits & Pension Summit Coverage.