This is the second part of a two-part series. See part one: The hunt for yield.
While fixed income strategies have long been recognized as good sources of cash flow generation, alternative investments (real estate and infrastructure) and equity strategies are other useful options to help meet the needs of pension plans focused on high yield.
Table 1: Yield-oriented asset classes
|Government bonds||Real estate||Dividend equities|
Government and provincial bonds represent the lowest default risk within fixed income strategies found in Canada. Given their taxation power, governments have a low risk of default and a high probability of payment in full. This means that the overall value of government bonds will be more stable than other fixed income strategies of a similar investment term.
Provincial bonds offer a yield in excess of Government of Canada bonds given their smaller size and taxation base. This additional yield is known as the provincial spread.
In most market environments, investors can generate additional yield by investing in bonds with a longer investment horizon. We can see this in the Canadian yield curve, which plots the interest rate earned by Government of Canada bonds of differing maturities.
But while government bonds are generally thought of as low risk, we are starting to see global examples of higher sovereign risk (the potential for a government to default on bond obligations). For example, we are now seeing daily news reports on the default risk of Eurozone countries such as Greece, Portugal, Ireland, Italy and Spain.
These examples highlight how government bonds can become risky for investors if debt levels are not managed. Additionally, even countries with low default risk can see an increase in return volatility, particularly in longer-dated bonds, if and when interest rates start to rise.
Since corporate bonds are issued by companies, the underlying sustainability of a business is important when determining its ability to fulfill debt obligations. Due to this greater uncertainty, corporate bonds provide a return above government of Canada bonds. Including corporate bonds and their extra yield in an overall bond portfolio can improve return and cash flow. By purchasing a diversified basket of corporate bonds, investors can also reduce the risk of default from a single issuer.
In Canada, this corporate spread for ‘A’-rated (indication of quality) bonds has ranged from as low as 0.6% to a peak of 3.7% during the financial crisis. This range is largely driven by market sentiment on the strength of the overall economy. When markets are strong, investors demand a lower premium for taking on the risk associated with investing in corporations. In times of financial difficulty, this risk premium will rise, which will decrease the value of corporate bonds.
Lower quality corporate bonds, known as high-yield bonds, offer the potential for even greater returns. The spread above government bonds typically ranges from 5% to 10% depending on the market environment. Over the last 10 years, this has more than compensated investors for the default rate experienced. But Canadian investors need to venture outside of our borders to access high-yield debt as the domestic market is very thin.
The U.S., for example, has a developed high-yield market, but investors need to be cognizant of the need to hedge currency risk when choosing foreign fixed income exposures. While high yield may make sense from a strategic perspective, current spread levels are low relative to history (meaning less yield for the risk taken). Additionally, the lower default experience of recent history is not necessarily indicative of the future. Higher default rates would cut into realized returns.
Mortgages occupy a unique space as both a fixed income asset class as well as an alternative. This is due to the private nature of the assets. Most homeowners know the basics of a mortgage—a loan secured by the underlying real estate.
Similar to a bond, the borrower agrees to repay the loan and interest on a predetermined schedule. Mortgages typically give investors a higher return than bonds in a stable interest rate environment. Moreover, rising interest rates have less of an effect on mortgages since they have shorter maturities. The average duration of a mortgage portfolio is typically three to five years, while a traditional bond portfolio’s duration is five to seven years. Despite the shorter maturity, the yield on a commercial mortgage portfolio is about 1.5% higher than the DEX Universe Bond Index (at June 30, 2012).
All of the aforementioned fixed income securities have the potential to rise and fall in value over the investment period. That said, if they are held to maturity and do not default, there is no permanent capital appreciation or depreciation. On the other hand, there are cash flow generating assets in the alternatives and equities space that do not have set maturities and can provide the potential for capital appreciation (or depreciation).
Real estate and infrastructure are the two primary cash flow-generating alternatives that Canadian institutional investors have turned to in recent years.
As stated in Managing asset allocation with alternatives, alternative investments generally offer comparatively superior returns to public assets because of their private/illiquid nature, the smaller base of investors chasing these investments and, in some cases, because they manage the use of leverage (debt). Most assets that are not widely traded need to compensate investors because they can’t be easily converted into cash in the near-term. A pension plan, with its long-term horizon, can usually harvest the liquidity premium.
From a liability matching perspective, the cash-flow-generating nature of real estate, infrastructure and mortgages makes them sensitive to interest rate movements. This is important because interest rate movements also affect DB plan liabilities. Moreover, real estate and infrastructure help protect a plan from inflation—real estate because its assets tend to appreciate along with inflation, and infrastructure through contractual agreements that link cash flows to consumer price index.
The private nature of these asset classes also results in a higher than expected cash flow yield to compensate investors.
Equities are traditionally classified as purely return-seeking assets for pension plans. While dividend-oriented stocks do not entirely change this dynamic, they can provide a measure of stability to overall returns as well as readily available cash flow streams to help fund benefit payments.
The potential for capital appreciation and cash flow/dividend increases due to inflation makes real estate, infrastructure and high dividend equities attractive options, though investors must keep in mind the fact that cash flows are not contractual. There exists the risk that dividends may be reduced due to company financial stress or increased cash flows required for maintenance of a property, toll road or power plant, thereby reducing distributions to investors.
There are many options available to investors searching for yield. The choice of which assets to utilize will depend on whether the investor’s intent is to hedge other risks such as inflation, and where the investor feels most comfortable on the risk/return spectrum.