With bond returns tied to interest rates, it’s no surprise Canadian pension funds are increasingly seeking other ways to boost fixed income yields.
Canadian interest rates have been trending downward for the last 30 years, from a high of 10.3 per cent in 1990 to around 1.75 per cent in early 2020, according to the International Monetary Fund. Rates were trimmed even further following the World Health Organization’s declaration of the coronavirus pandemic on March 11, 2020, with overnight interest rates immediately dropping from around 1.25 per cent to 0.75 per cent and, by the end of the month, to an historic low of 0.25 per cent, according to Statistics Canada.
In mid-April 2021, the Bank of Canada announced it would maintain that 0.25 per cent rate until inflation returns to two per cent, which it forecasted for the second half of 2022. While the fixed income component of Canadian pension funds — particularly domestic fixed income — was relatively static for several years, plan sponsors are taking a wider view to generate higher returns, says Robert Pemberton, head of fixed income at TD Asset Management Inc.
“What we’re seeing now is a broader shift to a more holistic view of the portfolio and, while the allocation to fixed income may not have changed, the components within it have. For example, there’s more global exposure, or corporate exposure, or real assets that are incorporated in the fixed income portion because they generate income on a regular basis.”
Michael Peck, senior vice-president and head of institutional investments at Invesco Ltd., says there’s no simple answer for how Canadian pension funds are approaching the fixed income portion of their portfolios. “A lot of pension plans are really taking a serious look at what to do next, considering capital market assumptions for the fixed income asset class in general aren’t as attractive as they used to be. And given [pension plan managers] have these actuarial needs to meet, they need to pick up returns somewhere.”
Going beyond core
The search for fixed income returns is leading pension funds to look beyond passive bonds in the pursuit of alpha, particularly as government debt grows and accounts for a larger slice of the FTSE Russell Group Canada Universe Bond index, squeezing out corporate credit investment opportunities, says Avi Hooper, portfolio manager for fixed income at Invesco.
“With passive bonds, it’s just replicating the index. The challenge of the index today is that 73 per cent is government debt and only 27 per cent is investment-grade Canadian corporate. As we go forward, the federal and provincial governments will continue to run larger and larger fiscal deficits and will continue to issue debt to fund these deficits. The amount and weight of government debt in the index, or a passive scenario, will only continue to grow and it will limit opportunities.”
Hooper says the first natural extension for most pension funds is to take traditional core Canadian fixed income exposure and add some diversification with a core-plus mandate, including the use of emerging market debt, high-yield debt or foreign bonds to generate higher potential returns with added credit risk.
“Over time, what we’ve seen is through credit research, investors who take on credit risk and focus on individual issuers within that portfolio have historically generated excess returns. It’s a question for pension funds — whether they want to take on credit risk and then where to seek that credit risk?”
Despite international fixed income investments being capped at 30 per cent in the index, Hooper says that part of the portfolio plays an important role. And while many of these investment opportunities are within the investment-grade space, returns can also be found in external debt issued by foreign governments that’s been denominated in hard currency, such as U.S. dollars or euros.
“We’re not seeking the currency-risk portion — we’d always hedge that out — but what we’re isolating is the credit risk. We can lend to a government that happens to be in an emerging market, but it’s [single A] or [double A] rated. It’s that balance of maximizing return without giving up the high-credit quality we’re seeking to provide to investors.”
Private debt, corporate credit opportunities
With many sectors, such as infrastructure and energy, requiring funding for projects, investment opportunities exist for pension funds in private debt that isn’t issued in the public market by large corporations, says Pemberton.
“There’s a number of ways of doing this and it’s something that pension investors are interested in taking on, particularly if they do it in the investment-grade space. Some are looking at it in the high-yield space, though, substituting that in their liquidity buckets when looking at overall portfolio construction. In private debt, you’re looking at yields of 150 to 200 basis points above — so 1.5 per cent to two per cent above — what you’d earn in the corporate credit space for the same type of risk.”
A private debt strategy leverages what Pemberton describes as the uniqueness premium — the incremental yield the plan earns for owning something that isn’t readily tradable in the public market. “We try and ensure that the uniqueness premium is representative of the incremental difference between a publicly rated and issued corporation and a private one. That uniqueness premium is something that the plan sponsor can harvest for the life of the investment.”
With pension liabilities long term in nature, plan sponsors can also consider taking on an active public corporate credit portfolio to increase the yield of their assets, he notes. “High-yield securities have yields of 4.5 per cent to five per cent, compared to a corporate bond in the investment-grade space, which have yields of 2.5 per cent to three per cent, depending on the issuer. That’s far better than the 10-year yield on the Canada bond right now, which is at 1.5 per cent and, when you account for inflation, it’s negative-30 basis points. That’s not going to provide a pension fund with the outcome they need if they’re invested solely in sovereign [bonds].”
And as part of the larger portfolio picture, Pemberton says these strategies can help ensure varied cash flows for pensions. “By creating integrated portfolios where you generate income from several sources, you can decrease volatility of the asset base relative to the liabilities and generate cash flow series which provide the pension plan with the income off the portfolio at a regular basis. Those types of solutions are certainly things in a low interest rate environment that are being investigated by more plan sponsors.”
David Ross, managing director of the capital markets group at the OPSEU Pension Trust, says the plan is approaching fixed income cautiously. In 2020, it significantly reduced fixed income exposure by cutting nominal bond exposure in half.
“It really didn’t make a lot of sense to hold that same level of bonds. They served us well historically as a liability and risk mitigant, but given the asymmetric return profile moving forward and the global backdrop, the prudent thing to do was to reduce that exposure. I don’t see that allocation changing much this year, but yields have backed up in the first quarter and my expectation is that we still have some upside for yields given the backdrop. We still hold some bonds and we’ll look to reintroduce more when we feel the risk/reward ratio is better for us.”
While the OPTrust’s bond exposure is predominantly within developed markets, Ross sees opportunities within the credit space in emerging markets — particularly within loans and structured credit, which are accessed through external managers — in industries poised to recover from an economic reopening, such as transportation, basic materials and industrials.
“The portion they’re running against our benchmark is positioned a bit defensively. They’re avoiding duration given what’s been going on with the underlying nominal bonds and they’ve focused on sectors that they expect to benefit from the recovery of economic activity this year. There’s a bit of a dual approach there – being defensive while also being opportunistic for those sectors that have been beat up [by the pandemic].”
Jérôme Marquis, managing director and head of corporate credit at the Caisse de dépot et placement du Québec, says the pension fund is continuing a diversified fixed income strategy that began in 2016. Instead of increasing fixed income returns through additional risk taken on in its bond portfolio, he says the Caisse leveraged its flexibility and investment expertise to generate returns through private debt, including through premiums stemming from liquidity and complexity.
While the pension fund’s private debt allocation was approximately $16 billion at the end of 2016, he says that amount more than doubled to $35 billion at the end of 2020 and is on track to reach $50 billion over the next two to three years.
“We took that route because when you’re flexible, [invest] long term and have expertise, you can generate more returns by not necessarily taking more risk, but through liquidity premiums. You want flexibility as a company? I’ll give you flexibility — but you’ll pay for it. If you come to us and it’s complicated, because of the teams some pension funds have, we can implement a solution that might not be accessible through the public market. Ultimately, we’ll get a premium because it’s complicated. I’m not increasing my risk, I’m just playing on the liquidity premium and the flexibility I’m providing to companies.”
In addition to increased private debt allocations, the Caisse also created a capital solutions group in 2017 to generate innovative solutions through what Marquis describes as hybrid approaches that are outside of typical classifications of equities or debt, including royalties and the monetization of cash flows.
“Their role is to provide innovative solutions through products not accessible to everyone, because you need creative people to find these solutions. But we’re [a] long-term [investor] and have expertise so you can generate returns not necessarily by taking on more risk but by providing innovative solutions. . . . We’ve built a well-diversified credit portfolio, with corporate, real estate, infrastructure and a bit of leveraging markets. But the majority of growth is coming from private debt strategies and the capital solutions group.”
While the early stages of the pandemic forced the Caisse to play defense and review its credit portfolio, Marquis says its long-term strategy remains the same, with a focus on investments in stable sectors including health care and software.
“We’re lucky we weren’t in the most affected sectors. You’ve got to choose well and it’s key in credit to review your portfolio. Once that work was completed, we started to play offense again. Now markets have returned, capital is there and the market is active so it’s more competitive.”
Blake Wolfe is an associate editor at Benefits Canada.