A decade of market ups and downs have pushed more and more pension plans towards de-risking solutions requiring greater fixed income exposure, noted Carl Bang, president of Sun Life Investment Management Inc. He was speaking at the 2015 Investment Innovation Conference in Los Angeles. During his presentation, “Innovative Investment Solutions in a Low Return Environment,” he explained that, as plan sponsors consider a broader fixed income toolkit, including private debt, they must look more closely at the question of liquidity.
iting a recent poll of top plan sponsor challenges, Bang noted most respondents were concerned with interest rates (78%), market volatility (67%) and under-performing equity markets (40%). “2015 has been a wake-up call on both interest rates and equity markets,” he said, adding that “equity markets are now facing significant headwinds and have declined in most of the world’s regions. Banking on equities to provide the returns you need is a risky business.”
At the same time, rock bottom rates make asset-liability matching through bonds exceptionally challenging.
The Illusion of Liquidity
So what is the solution? Private fixed income, including lending and mortgages, can help add the right level of diversification, provided plan sponsors can set aside their concerns over liquidity and challenge their assumptions around what Bang called “the illusion of liquidity” in public corporate bond markets.
“We’ve all heard of the liquidity premium — the additional return that a fund expects for locking up its money in a liquid investment,” said Bang. “But what happens if a previously liquid investment loses liquidity even as you hold it?” That could happen, especially now, he explained, adding that the Volcker Rule now prohibits short-term, proprietary trading of securities, which has been instrumental in shrinking dealer inventory and risk appetites. As a result, dealers are less able to provide the immediacy of liquidity that they used to, and neither the quantity nor price for public corporate bonds has certainty.
“Simply put, investment banks won’t buy unless they know they can sell – and the result is a much lower inventory and less immediacy in terms of trade, hence much less liquidity in [the] corporate bond market,” Bang explains.
Bang pointed out that, in the face of declining liquidity, pension funds ideally should have two buckets for fixed income: government bonds, which are liquid; and non-government bonds, which are illiquid. In that context, private fixed income allows plans to trade some liquidity for additional yield while diversifying risk, without adding duration or credit risk.
“Pressure is only building on pension funds to find ways to increase returns without increasing risk,” Bang concluded. “Liquidity is an asset that pension plans may be overlooking as a source of opportunity to added returns.”