Ultra-low yields in a potentially volatile global and domestic macroeconomic environment create a number of challenges for global pension plan sponsors—and 2012 will indeed be the year of difficult decisions.
For many plan sponsors and their consultants, the decisions will boil down to answering a single question. How can plans generate better returns while simultaneously de-risking or maintaining a low-risk portfolio?
On the whole, this might seem like a daunting task. On the margins, however, there may be a fairly simple way of improving the portfolio’s overall return by focusing on where the impact can be the most notable: in the long-duration fixed income component. The proposition of a long infrastructure bond strategy is to do just that.
Long investment strategy landscape
Over the past few years, many plan sponsors have already adopted—and benefited from—some form of duration extension or liability driven investing (LDI) approach. By extending the duration of their assets, these plans were better able to match the increase in the value of their liabilities (a function of being forced to apply lower discount rates because of low yields) with a corresponding increase in the market value of at least a portion of their fixed income portfolio.
While for many it was a step in the right direction, this is an imperfect solution. One clear weakness resides in the fact that traditional LDI and duration extension strategies generally provide low returns, with little in the way of alpha-generating potential.
To put that statement in perspective, consider the following. At the end of March 2012, the DEX Long Bond Index was composed of 78% government bonds. While long Government of Canada bonds were yielding 2.56%, the DEX Long Bond Index had a yield of 3.51%, and the DEX Long Provincial Bond Index had a yield of 3.57%. (In the context of 2% inflation, these yields seem pretty low.)
For plan sponsors with long passive index strategies—which would have performed reasonably well while rates were declining—as policy interest rates began to find a floor, this long bond return becomes almost laughable.
For active long bond managers, the high government bond concentrations in these indices make it difficult for them to generate meaningful excess returns without taking undue risk. In 2011, this became apparent when a number of active bond managers materially underperformed the benchmark as a result of their views on credit or duration. To be fair, a handful of managers were able to outperform, but the point remains that the divergent returns evident during this period should give plan sponsors cause to re-evaluate.
With yields as low as they are, every basis point of added value under a long-duration strategy is extremely valuable to a pension plan sponsor. This has led many sponsors and consultants to get more creative in identifying and allocating money to investments or strategies that offer a better risk/return proposition.
Challenges and opportunities in infrastructure bonds
Last year, the first infrastructure bond strategy in Canada was launched to capitalize on opportunities arising from Canada’s rapidly growing infrastructure debt market. The strategy is based on the view that a well-managed, high-quality portfolio of select infrastructure bonds can deliver a low-risk but higher-yielding complement or alternative to traditional long-duration fixed income strategies.
Plan sponsors and consultants are often well versed in the opportunities that exist in the infrastructure equity side of the market. However, they generally give far less consideration to the fact that these infrastructure deals require significantly more debt than equity.
As governments in the face of fiscal restraint look to lever private investment to deliver essential infrastructure on time and on budget, the pipeline of potential activity is significant. With the pullback in long-term bank lending available from European banks—the combined result of global sovereign issues and higher capital costs—there is a significant and growing need for long-term debt capital.
These factors create an ideal environment for attractive investment opportunities. Last year, more than $4 billion of rated public-private partnership infrastructure bonds were issued in Canada. New issues typically provide a yield of more than 200 basis points over the relevant government bonds and have approximately a 12-year duration. The attractive yield and long duration make them a natural fit for pension portfolios.
Core to the strategy, however, is the ability to separate the good deals from the bad in order to maintain the low-risk proposition. As with infrastructure equity and real estate, all deals are not created equal.
Infrastructure bond deals are document-intensive. The projects and financial structures require significant upfront due diligence. But the work only begins there. As experts will attest, the bulk of project risks only materialize after shovels get into the ground, so ongoing active monitoring is essential. Assessing the risks and determining fair pricing for the bonds require highly specialized expertise—both technical and financial—that could be difficult to find with traditional bond managers.
Another challenge to the strategy is that it is capacity-constrained, based on annual deal volumes. Ultimately, Canada’s urgent need for infrastructure will be tempered by the pace of the associated political process which, albeit far better than the U.S. experience, can be quite slow.
As a result, the deployment into the strategy will be gradual as new deals come to market. What this means for plan sponsors is that it takes time to get their commitments to an infrastructure bond strategy fully invested. It also means that as interest builds in this type of strategy, would-be investors may find themselves at the wrong end of the queue.
An infrastructure bond strategy will certainly not solve all of the problems that today’s pension plan sponsors face. However, it is a tool that may improve portfolio returns in a meaningful way without straying from the plan’s low-risk proposition. And with the potential of adding 50 basis points or more net of fees, the added value could be significant.
After all, every basis point matters—particularly in long bonds.
David Frei is vice-president and portfolio manager, infrastructure fixed income funds, with Fiera Capital Corporation.