As the objectives of defined benefit pension plans have evolved, so too have institutional investors’ reasons for including fixed income allocations in a portfolio, from adding diversification and offsetting negative returns in equity to liquidity management and capital preservation, said Ashwin Gopwani, managing director and head of retirement solutions at Sun Life Capital Management, during the Canadian Investment Review‘s 2023 Investment Innovation Conference in November.
As DB plans have larger retirement populations compared to the active population supporting them, these plans are starting to see more money go out than come in, he said, noting the quality of fixed income in generating coupons that can be used to payout retiree payments is actually increasing in value for plan sponsors.
“You don’t need to generate transaction costs in order to pay pensioners when you have income coming in the door. But, in a time of a downturn, it also helps you to not have to sell assets at a loss. You don’t have to sell your depreciated equity portfolio if it’s a bad time if you’ve got these stable payments coming in.”
Fixed income is increasingly playing a yield enhancement role in portfolios, as well as in liability hedging. “Before, I would have said liability hedging just meant hedging interest rates, but now people are thinking about their inflation risk, curve risk and credit risk. There’s generally been a broader theme for how fixed income could help hedge some of those risks.”
Also speaking during the session, Véronique Lauzière, SLC Management’s managing director of business development, noted in 2023, closed DB plans were just trying to preserve capital and ensure they kept a surplus on the balance sheet. However, open plans need to pay out retiree benefits and therefore need more predictable returns from their portfolio.
As well, the asset classes within fixed income have evolved in terms of what they’re able to do for a portfolio, she said, noting compared to fixed income, equity risk premiums have shrunk. These asset classes have gained some familiarity, so investment managers have begun building specialty products that allow all plan sponsors to invest in them. “We’re in a different environment than we were three years ago. It makes a lot of sense to think about whether some of these different asset classes, and the additional characteristics that fixed income can provide, are worthwhile for considering the role that they can play in your portfolio.”
The fixed income toolkit has also evolved and fixed income assets are able to better balance risks with liabilities within portfolios. One way to do this is by increasing duration, as well as by increasing corporate exposure by having exposure to long corporate bonds plus a base of long provincial and federal bonds. “We have improved the expected return, because we added some credit risk to the portfolio and we are reducing the funded status volatility, by adding credit risk,” she said. “By increasing duration, we’re actually matching liabilities much better.”
Institutional investors can also use fixed income to improve their risk profiles, diversify their credit and earn a little bit of additional return, said Gopwani. One strategy would be to take a portion of corporate bonds and replace them with non-traditional investment-grade level assets, such as mortgages and private fixed income. He noted this strategy would garner a higher level of return from a fixed income portfolio because private fixed income and mortgages have some illiquidity and structural premiums. It could also enhance credit diversification because the issuers within the private debt market, even in the investment grade space, don’t overlap fully with the issuers within the public debt space.
“There’s an opportunity to get a bit of name diversification within even just the corporate portfolio. And then, even the additional sleeve of mortgages gives you a different risk factor exposure than corporate loans, so there’s lots of correlation there that’s helping to improve diversification as well.”
Read more coverage of the 2023 Investment Innovation Conference.