According to a 2011 Greenwich Associates survey of Canadian institutional investors, the most important issue investors face is market volatility (47%), followed by rate of return and funding issues (34%).
With current bond yields hovering around 2.5%, how can plan sponsors make pension payments when their liabilities have increased?
Kevin De Sousa, portfolio manager, fixed income, with Phillips, Hager & North (PH&N), shed some light for fixed income investors at the PH&N Trustee Education Seminar last week at the Fairmont Royal York in Toronto.
Risks near and far for institutional investors
Volatility and the individual investor
Managing volatility in equity portfoliosFirst, he noted, this is an issue in many places, not just Canada. Ten-year government bond yields in the U.S., the U.K., Germany, Switzerland and the Netherlands are hovering around the 2% mark. That’s the good situation, he said. However, although it’s somewhat stable investing-wise, investors are not going to garner stellar returns.
Worse off are Portugal, Italy and Spain, which have recently yielded 12.06%, 5.70% and 5.39%, respectively. Better yields, certainly, but these countries have their issues. And then there’s Greece, at 30.20%. Enough said.
EMD and GHY
So how can institutional investors improve returns? De Sousa mentioned some widely adopted strategies, including active management, mortgages (to capture the illiquidity premium) and credit (provincial or corporate). And current somewhat widely adopted strategies are Canadian high yield and derivatives and overlays.
But just starting to come to the fore are emerging market debt (EMD) and global high yield (GHY). Though De Sousa said he hasn’t seen much take-up on these yet, EMD and GHY may be good options for investors in a low-bond environment.
As of Sept. 30, 2011, market yields on EMD and GHY were 6.5% and 9.81%, respectively. Compare this to the DEX Universe Bond Index (2.41%) and the DEX All Corporate Bond Index (3.31%).
De Sousa pointed out the following positives for emerging markets:
- higher existing growth rates and more room to grow;
- stronger demographics;
- lower sovereign balance sheet risk;
- risk/reward ratios that make some sense; and
- low correlation with other assets (most of the time).
And emerging markets are growing. According to research from Haver Analytics, in the 1970s, emerging markets contributed 22% to global GDP; by the 2000s, that contribution was almost half (47%).
Emerging market risks
While some investors may think emerging markets are risky, De Sousa tried to put these risks into some context. He explained that PH&N analyzed a number of different Canadian bond portfolios that introduced various combinations of GHY and EMD, with a limit of 20% used for these latter asset classes. Three sample portfolios were shared at the seminar:
- 80% DEX Universe/20% GHY;
- 80% DEX Universe/20% EMD; and
- 80% DEX Universe/10% GHY/10% EMD.
The analysis showed that all three portfolios increased returns without adding a dramatic amount of risk. PH&N also repeated the analysis within an asset/liability framework. The result was that a sample portfolio that added 20% in GHY and EMD to Canadian long bonds showed an increased return compared to a fully domestic portfolio, with only a moderate increase in overall portfolio volatility.
In conclusion, De Sousa said that EMD is better quality and more established than many investors believe. Including EMD and GHY has merit in a Canadian fixed income portfolio as a strategic asset, and improves the risk/reward profile.