Bond ambition

Fixed income is a key component of a pension plan’s portfolio. What new options are emerging in the search for yield?

Gentlemen may prefer bonds, but for pension investors, fixed income is necessary—even if the returns aren’t ideal. For DB plans, bonds play a very important role in matching the liabilities and reducing interest rate risk.

Unfortunately, most plans are not well hedged, says Marlene Puffer, a partner with Alignvest Investment Management. “They still have, for the most part, universe bond mandates rather than long bonds and a portfolio of fixed income that’s too small to truly hedge the interest rate risk.”

Add in a low interest rate environment, and that creates frustration with the fixed income portion of the portfolio. As a result, institutional investors are looking for enhanced returns in fixed income and/ or interest rate protection while trying simultaneously not to alter their risk profile, says Carlo DiLalla, vice-president, fixed income institutional advisory group, with CIBC Asset Management Inc.

Traditionally, fixed income has been more of a passive balance to the portfolio to hedge the interest rate risk of the plan’s liabilities, agrees Aubrey Basdeo, head of fixed income for BlackRock Canada. He says most investors tend to think that when rates rise, fixed income assets don’t do as well and when rates fall, they perform better. But, in 2013, Basdeo continues, this “erroneous thinking” was exposed. “Parts of fixed income markets do well despite a rising rate environment,” he explains, citing high-yield bonds, which produce a positive return and therefore provide a spread that cushions some of the interest rate risk, as an example.

Part of the issue is just when interest rates will begin to rise. That’s anyone’s guess. In the meantime, here are five options that institutional investors are exploring to improve their fixed income portfolios.

1. Global Fixed Income/EM Debt – According to Dany Lemay, senior consultant and investment leader with Towers Watson, the fact that interest rates are low and have remained so for a while has pushed investors to look outside of Canada— which is a good thing from both return and risk perspectives. And there are a lot more opportunities now. “Back in the 1990s, almost 100% of emerging market sovereign debt was non-investment grade,” says Rob Pemberton, managing director, head of fixed income, with TD Asset Management. “Today, about 72% to 73% of that broadly defined sovereign market is investment-grade credit.”

According to Basdeo, the Canadian fixed income market is about 3% of the overall global market, leaving 97% of fixed income markets outside of Canada. “That’s a pretty rich universe to tap into,” he says, adding that once the cost of hedging is accounted for, investors can still get some attractive returns.

In general, Basdeo thinks emerging market (EM) debt offers compensation for the risk that an investor is taking. “It may look like very low yield today, but relative to what developed markets are offering, EM debt is still a high-yielding part of fixed income markets.”

However, Puffer says investors need to watch out for bubbles in corporate bonds in some countries. “The sovereign may be in good shape, but there’s been an enormous amount of corporate bond issuance—some in local currencies; some in U.S. dollars—in many of these countries,” she explains. “You have to look inside and see how much of a threat the private debt burden is in the individual emerging market.”

While there has been concern about liquidity in EM corporate bonds, the EM corporate debt universe sits at US$1.3 trillion—larger than the EM government bond universe and the European high-yield market combined, according to the Bank of America Merrill Lynch US High Yield Index (September 2012).

2. High-yield Bonds – Back in the ’80s, high-yield bonds were known as junk bonds. “It was called a ‘fallen angels market’,” says DiLalla. “It was made up of securities that had gone through bad times, or it was a market of highly leveraged companies being aggressive with their business plans.” While there are still elements of this in the high-yield space, he adds that it’s a much more established market today, which pension plans are beginning to realize.

But in high-yield bonds, Basdeo says investors need to think about what part of the economic cycle they’re in and therefore make decisions on when to actually be involved in this space. For example, in the late stage of economic recovery, investors should be concerned about the default rates and increased volatility, he says.

Conversely, in the early stage of recovery, companies will be in a healthier economic state and will likely be able to honour their debt obligations and interest payments, and high yield does relatively well, he adds.

3. Convertible Debt – With convertible debt, the bond is convertible into equity. “Convertibles are often issued by companies that can’t access the regular debt market; therefore, many of them are of poorer credit quality and, as a result, often not rated,” says DiLalla. But opportunistic allocation can enhance return and improve diversification, he adds.

Convertible debt is used mainly by hedge fund managers and proprietary traders, says Puffer. “Very few straight-up pension fixed income mandates would allow convertible debt because if they want equity exposure, they get it through their equity portfolio.”

But Basdeo says he’s seen a small number of investors look at convertible debt and preferred shares to generate some income and diversify within the fixed income portfolio.

4. Preferred Shares – Preferred shares have more appeal for retail investors, but Lemay has seen a few institutional investors consider them. According to Basdeo, most pension plans tend to bucket themselves, with fixed income in one bucket and equity in another.

However, preferred shares are a hybrid asset class, combining equity and fixed income-like yield—and that’s where the trouble lies. Where does an institutional money manager put them: in the equity pool or the fixed income pool?

“I wouldn’t say I’ve seen many plan sponsors include them in their fixed income bucket—although you may argue that they provide a fixed income, especially in cases where they try to have a fixed income portfolio that, in aggregate, provides diversified sources of return while doing a decent job of hedging their liabilities,” says Lemay. Puffer agrees that preferred shares would typically fall into equity and, therefore, would not be an option to improve the fixed income portion of a portfolio.

5. Floating-rate Debt – One other issue to keep in mind in this low-rate environment is the fact that, at some point, rates will rise. Some in the industry, Puffer explains, are exploring floating-rate debt (in which the rate of interest on the bond adjusts, usually every quarter) as the answer to rising rates.

When interest rates start to rise, floating-rate debt will work to the investor’s advantage: when the rate is reset, the price of the bond won’t drop. But there’s a caveat. “While you’re sitting in those [instruments], waiting for rates to rise, you’re losing money every day relative to having fixed rate debt,” Puffer adds.

With yields likely to stay low for the foreseeable future, money managers suggest that pension plans consider different options within the fixed income space. But whatever the approach, risk will be an important consideration.

“In a low interest rate environment, you’re looking for all of your assets to work for you,” says Basdeo. “So the fixed income portion would be looking at parts of the fixed income market that can earn a higher yield—assuming you’re willing to take the risk that comes with that.”

The Trouble with Bond ETFs

One option that pension investors might want to steer clear of right now is bond exchange-traded funds (ETFs). Carlo DiLalla, vice-president, fixed income institutional advisory group, with CIBC Asset Management Inc., says they’re not a “prudent method of accessing yield. I personally believe it’s akin to buying residential real estate property without conducting due diligence. You wouldn’t buy a place without inspecting it or comparing it to other properties. Nor do I believe that you should rely on rating agencies and index providers to determine your basket of securities.”

ETFs are usually used in transitions. “If a client transitions out of one sector and wants to expose itself to high yield, it may buy the ETF temporarily until the fund gets fully invested in high yield,” says DiLalla. But he doesn’t believe they’re a good vehicle for the long term. ETFs were first developed to cover some quality markets. “Over time, their acceptance has led to more exotic ETF launches such as high-yield and emerging markets, which are less efficient markets and should probably not be accessed passively,” DiLalla adds.

Rob Pemberton, managing director, head of fixed income, with TD Asset Management, says investors need to remember that if they have a relatively large exposure to ETFs in the emerging market (EM) space and they want to exit those funds, “some ETF providers have the right to give you the underlying securities on a pro rata basis, not cash. So now you are a forced seller of bonds in a marketplace for which you may have no expertise or contact—or your custodian, which may not have the broad market experience, is doing it on your behalf.”

While bond ETFs are a quick and easy way to get a diversified portfolio, versus buying individual bonds, Marlene Puffer, a partner with Alignvest Investment Management, says you need to know what you’re buying. For example, do the bonds in the portfolio have staggered maturity levels or a targeted maturity date? “It’s very easy to be surprised by the total return on these funds relative to what you expect when interest rates move around,” she says. “They can behave in ways that are surprising.”

She also notes that, for smaller pension plans in the EM space, there are issues in trading EM debt, such as dealing with the currency risk. “An ETF can reduce the challenges there, but you want to know whether the currency is being hedged or not, and you want to know what [the country’s] investment policies look like.”

Brooke Smith is managing editor of Benefits Canada.

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