Extraordinarily low interest rates are one of the legacies of the recent financial crisis: as of July 2012, the Bank of Canada has fixed the overnight rate at 1%, and the 30-year bond yield stands at around 2.6%. Such low rates have particular implications for pension plan sponsors seeking returns in the fixed income asset class.
Since pension plan liabilities are inversely related to interest rates, these liabilities have increased in recent years. Indeed, with some Canadian government bonds currently yielding less than inflation, fixed income investors are facing the spectre of negative real returns. Combined with the possibility that inflation could further increase—or that policy rates could increase as the economy improves—it is hard to make a case for plain vanilla Canadian government bonds.
Within a pension offering, it is not enough to hope that the performance of some asset classes will make up for shortfalls in others. Investors and trustees need to pay more attention to their fixed income allocation and find ways to make these assets work a lot harder. To this end, several areas of fixed income are worth exploring.
Foreign opportunities
The Canadian bond market is heavily weighted toward federal and provincial government bonds, and these types of issues tend to have lower yields. Furthermore, in Canada, corporate bonds are skewed toward the financial sector. But the Canadian bond market comprises just 3% of the global bond market. This presents potential opportunities for Canadian pension plans that have traditionally focused on domestic bonds.
The much larger U.S. bond market, for instance, has proportionally more non-financial corporate bonds, allowing for improved security selection opportunities and diversification. It is also possible that because of Canada’s relatively strong economy, the Bank of Canada may act more aggressively in raising rates than other jurisdictions. This, of course, would have negative implications for institutional investors that are overweight in Canadian bonds, raising a strong argument for pursuing more global diversification options.
Non-traditional fixed income
High-yield bonds and emerging market debt are two examples of non-traditional fixed income asset classes that are under-represented in Canadian pension plans. Because of the higher rates on offer, these types of bonds may outperform Canadian bonds on a long-term basis.
High-yield bonds, for example, have a very attractive risk/reward profile and may offer equity-like returns in favourable market environments while being higher up in the capital structure. Emerging market bonds benefit from favourable long-term dynamics and economic growth, which support underlying credit quality, while also offering potentially better yields than developed markets.
Meticulous and rigorous credit research provided by corporate and sovereign analysis resources is key for controlling the risks in high-yield bonds and emerging market debt, and for investments in these asset classes to be successful.
In order to respond to the significant challenge of meeting pension liabilities in today’s low-yield environment, plans need to be willing to move away from a purely domestic focus and enhance their fixed income yield. While Canadian plans should still maintain a core fixed income allocation in Canadian bonds (particularly in well-researched corporate bonds), they should not ignore other global opportunities within the fixed income asset class.
Canadian pension plans should assess the opportunities for potential returns in global markets while also understanding and managing risk.
Alexander Schwiersch is a portfolio manager with Aberdeen Asset Management Inc. alexander.schwiersch@aberdeen-asset.com
Get a PDF of this article.