Pension investors have always relied on bonds as a steady source of diversification, capital preservation and a hedge for liabilities. But since the 2008 financial crisis, the once-sleepy fixed-income space has transformed into an ever-expanding universe of global bonds, credit and other new products meant to satisfy a growing appetite for yield.
As interest rates test new lows and liquidity challenges mount, plan sponsors face tough choices around their bond allocations. And while many continue to stick with the status quo, there are a growing number of plan sponsors making major changes in response to the new realities of the fixed-income landscape.
Long-term issues
The challenges in the bond market aren’t going to disappear any time soon. As Alan Cauberghs, senior investment director for fixed income at Schroders in London, England, explains it: “Long-term debt dynamics in both the private and public sector will continue to drag on growth for years to come.”
Right now, developed economies are “in a situation with high levels of debt to support based on low and lower growth,” he adds. As interest rates test new lows — and in some cases fall below zero per cent — Cauberghs notes it’s becoming harder for plan sponsors that have to discount their liabilities at realistic rates.
Another major issue in the bond market today is supply constraints. “Over the last 12 months, it’s become difficult to impossible to trade all but the most liquid treasuries or government bonds,” says Cauberghs. That’s because investment banks have pulled out of their role as market makers in the wake of the Dodd-Frank Wall Street Reform and Consumer Protection Act, something that’s a big problem for plan sponsors that rely on large bond allocations for liquidity.
Bonds at home
In Canada, the fixed-income space has also changed dramatically over a relatively short period. Rob Pemberton, head of fixed income at TD Asset Management in Toronto, notes the Canadian bond market has more than doubled in size in the last few years. At the same time, the growing corporate bond space has become more concentrated in triple-B bonds, which is a challenge for plan sponsors that rely on double-A credit for the discount curve, he adds.
Plan sponsors with long time horizons also face another hurdle around the high costs of ultra-long bond exposure, says Pemberton. While there’s a growing supply of such bonds coming from the government of Canada, the provinces and even corporations, they’re expensive, especially with rates at current low levels, he notes.
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Despite the changes in the fixed-income space, allocations to bonds appear relatively stable, according to the most recent data from the Pension Investment Association of Canada’s asset mix report. Between 2004 and 2014, the average exposure to Canadian nominal bonds inched down to 23.4 per cent from 27 per cent a decade earlier. Average exposure to foreign fixed income also remained low at 1.26 per cent in 2014 versus 0.8 per cent in 2004.
“When plan sponsors stick to the traditional model of 60-40 equities and fixed-income securities, it frankly beats me how they can justify the rationale,” says Zev Frishman, chief investment officer at Morneau Shepell Asset and Risk Management Ltd. in Toronto. “Most pension funds have return targets they need to meet in order to meet their long-term going-concern liabilities.”
Nowadays, most pension plans require real returns in the range of four to 5.5 per cent, he says. As a result, a plan sponsor with heavy exposure to more traditional long-term domestic bonds would have to set what Frishman calls “heroic” return targets from other asset classes like alternatives and equities to make it happen, he adds.
“If you have a 30 per cent or 40 per cent allocation in an asset class yielding far below your return requirements, how will you meet your overall return target? Currently, real yields for Canadian government bonds are negative all the way to maturities of 10 to 11 years. Very long-term government of Canada real-return bonds yield about 40 [basis points].”
THE ROLE OF FIXED INCOME IN PENSION FUNDS’ ASSET MIX
| Average exposure to Canadian nominal bonds | Average exposure to foreign fixed income |
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Source: Pension Investment Association of Canada’s asset mix report of sponsor organizations represented by its members
Rethinking the role of bonds
How should pension investors be responding to the changes? A first step is to think about the role, starting with liquidity needs, that bonds play in a pension portfolio. Pemberton sees more plan sponsors dividing their liquidity requirements into two buckets: one focused on near-term liquidity required to meet their ongoing obligations and another on longer-term needs over time. “In this longer-term bucket, plan sponsors are looking at private debt to enhance yield,” he says.
While it’s important to rethink the role fixed income plays in a pension portfolio, plan sponsors still have to find the bonds to do the job. “There is no free lunch when it comes to bonds, or any other asset class, for that matter,” says Frishman, noting there are fixed-income securities that can add higher-thanexpected returns and lower volatility.
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There’s a tradeoff, however. “Some securities might come with less liquidity,” he says. For example, many commercial mortgages have good credit quality and can offer as much as 200 basis points or more above bond rates but are not actively tradable.
“If you can afford to have somewhat less liquidity and go down a little on the credit scale, there are opportunities to help meet ongoing requirements,” says Frishman.
Some pension investors are already there. Jacques Marleau, deputy treasurer with the City of Montreal, says his plan began reducing exposure to bonds years ago, substituting other assets like infrastructure, global bonds, private debt and real estate. “A few years ago, due to the low interest rate environment, we reviewed our portfolio to introduce a core/satellite structure,” he says.
“We now have a low-volatility component to give us liquidity and steady cash flow, enhanced by a global credit exposure.”
For its part, the Healthcare of Ontario Pension Plan has a significant fixed-income exposure as part of its liability-driven investment strategy. While much of its bond holdings are meant to hedge the plan’s liabilities, senior vice-president and chief investment officer David Long notes the plan also takes an active approach to fixed income, including global bonds.
“We trade a number of international markets on an active basis,” he says, noting global bonds make a good deal of sense because they allow investors to take advantage of interest rates in various countries.
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Josée Mondoux, director of investments for the Canadian Medical Protective Association, doesn’t have the same constraints as a pension plan, but her fund is actively working to enhance its fixed-income exposure without increasing correlations to public equity markets. It’s the same challenge that all plan sponsors face and one her organization has been working on since 2015.
“Our target return is 5.5 per cent,” she says. “How do you achieve that given the current level of developed market bonds?” To maintain its risk and return targets, her organization revised its asset mix in 2012 to add exposure to emerging markets fixed income.
Today, it’s looking at tactical and strategic positioning for its fixed-income portfolio, examining core-plus exposure to credit, including corporate bonds, high yield and collateralized loan obligations, or using a derivatives overlay strategy to maintain duration and yet reach for a higher value-added target, says Mondoux.
There’s some risk, however. “If we add too much credit and move too far from a core bond portfolio, you can tip into equity-like risk,” she says. “We don’t want to lose the correlation benefits of fixed income.”
High-yield conundrum
At a time when added returns are important, highyield bonds are one area of fixed income that more and more plan sponsors now use. Cauberghs, however, sounds a note of caution around deteriorating fundamentals, looser covenants and heavy exposure to the U.S. and Canadian energy markets.
Long, however, notes that while yield spreads have been widening, there has been a rally recently that has benefited investors. “There is still some risk premium in high yield that might be worth accessing. It doesn’t feel tremendously overpriced given the return,” he says.
The big question facing investors today is what to do about rising interest rates. For plan sponsors with a heavy exposure to long-duration bonds, it’s definitely important to understand and deal with that prospect. But it’s a risk they have time to deal with, says Pemberton.
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“This will be the loosest tightening cycle in the history of the U.S. Federal Reserve,” he says. Still, plan sponsors should be educating themselves and their boards about the overall impact of rising rates over time. Being disciplined about developing a plan glide path will focus both sponsors and boards on the outcome, says Pemberton.
At the same time, there’s a silver lining. “As interest rates rise, a plan’s funded status can improve dramatically,” he says. “You need to think about the whole plan.”
Caroline Cakebread is a Toronto-based freelance writer.
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