Bond Ambition

So what has changed? The first thing is the level of interest rates. Gone are the days where you can expect to earn 10% from your bond portfolio. Many people took this for granted and only realized, belatedly, that interest rates had fallen significantly. Furthermore, many thought that interest rates would be rising again. The view held now by most market participants is that bonds will generate between 4.5% and 5.5% for the foreseeable future (and in fact have returned to a more normal level). Combine this with lower expected equity returns, accounting standards and solvency rules, and plan sponsors are now really concerned. This is especially the case as many defined benefit plans are maturing and require significant bond allocations.

Another major change was the removal of the foreign property rule. Most plan sponsors were hesitant to use up their scarce foreign property allocation on the lowly bond. With the removal of the limit, suddenly there was a whole world of bonds out there to consider—high yield bonds, mortgages, mezzanine debt, global bonds, emerging market debt to name a few. Many U.S. and European bond managers brought these strategies to Canada either on a stand-alone basis or as part of a core-plus strategy. Suddenly bonds were exciting! With the lower anticipated interest rates, many felt those large bond allocations needed to work harder, hence portable alpha engines that used bonds as a porting base.

The removal of the foreign property rule and the lower interest rate environment have also served as the impetus for a number of managers to engage in business combinations. The two most recent examples of this are Phillips, Hager & North and Royal Bank Asset Management, and Addenda Capital and Co-operators Investment Counselling. PH&N immediately gains access to the ‘plus’ sectors that RBC has developed and will be able to compete against the U.S. and European houses that have discovered Canada (again). Addenda enhances Co-operators’ corporate credit expertise and rounds out its business with equity capability.

The question we ask plan sponsors is: if you are already willing to consider portable alpha (which employs leverage) and plus strategies (which employ below investment grade debt and emerging market debt among other strategies), shouldn’t you also consider fixed-income substitutes such as real estate, infrastructure, mezzanine debt, etc.? Our concern is that plan sponsors are being seduced by all the new and exciting products out there without stepping back and really assessing what their plan’s goals are and their risk tolerance. For example, there are portable alpha products and income producing infrastructure products that deliver the same returns (or close enough). However, they have completely different mechanisms for generating return, have different life cycles and different risk patterns. Most importantly, depending on the role that each plays in the portfolio, one product may be a better match to the plan’s liabilities.

We think that the bond revolution has only just begun. We expect more fixed income and fixed-income substitute products to be launched, and potentially even more merger and acquisition activity among managers as they struggle to remain relevant to the marketplace and their clients. What we would like to see is more plan sponsors adopting a decision-making framework that examines the range of options and matches these to the needs of the plan (i.e., the liabilities) and the governance capability of the decision makers. Plan sponsors may end up with exactly the same decisions, but at least they would know how they got there. As for Daniel Craig, let’s hope his next foray as 007 proves as exciting as his first.