Bond market challenges are sending pension plans large and small in search of alternative strategies
Pension plans have historically relied heavily on fixed income investments. The regular interest payments on bond investments are good matches for the regular pension payments made to pensioners. At the same time, bonds offer safety of principal and lower volatility than stocks. Today, it’s common for many smaller plans, with assets under $100 million, to hold between 40% and 45% of the portfolio in a traditional or “universe” bond portfolio. More mature plans, with a high proportion of long-service members and retirees, may hold an even larger allocation to bonds.
Over the past three decades, the bond allocations of these plans have had a spectacular run of strong returns. Between 1980 and 2012, bond yields fell steadily from a high of 19.1% in 1981 to 2.3% in 2013 (see chart below). As bond yields fell, bond investments benefited from capital gains from their investments, and bond prices rose steadily as a result of falling interest rates.
Over this period, pension plans witnessed several serious stock market corrections, including Black Monday (1987), the tech wreck (2000) and the credit crisis (2008) (see chart below). As a result, the annualized return of the DEX Universe Bond Index, which tracks the Canadian bond market, actually outpaced that of the TSX (9.7%, compared with 8.4% as of Dec. 31, 2012).
Today, the DEX Universe Bond Index has an average yield of about 2.3% and a duration of approximately seven years. A seven-year duration means that if the yield curve (i.e., bond yields across the full-term spectrum) were to immediately shift up by 1%, the DEX would fall by approximately 7% (i.e., a return of -7%).
But as pension plans begin to look for alternatives in the face of the current investment environment—characterized by low and rising bond yields—factors that prevent smaller plans from getting exposure to certain asset classes could throw these plans a curve ball. Fortunately there are ways for smaller plans to work around these limitations and find fixed income yield.
In the first half of 2013, bond yields began to rise again. The yield of the DEX Universe Bond Index has risen by almost 0.5%, resulting in a negative return (-1.7%). Many economists expect bond yields to continue to rise, as central banks in North America begin to unwind expansionary monetary policy involving open market bond purchases designed to keep bond yields artificially low. Both U.S. and Canadian central banks have been signalling the slowing and eventual end of practices such as the U.S. quantitative easing programs, which have helped to maintain artificially low interest rates.
A low and rising bond yield environment will introduce new challenges for a generation of pension investors, many of whom have never experienced this type of bond environment. Pension plans can expect low or negative returns from their bond portfolios over the next three to five years.
So what’s a pension plan sponsor to do? Larger pension funds can use the following techniques to try to limit investment losses in their bond portfolios in a rising interest rate environment.
These fixed income investments act to shorten the duration of the bond portfolio. (Shorter duration bonds are less sensitive to rising interest rates, meaning that they will have lower capital losses when interest rates rise.)
• Canadian corporate bonds – A corporate bond fund comprises corporate bonds only. This fund will generally have a shorter duration than the DEX Universe Bond Index and will also provide a higher yield to compensate investors for a slightly higher risk of default, relative to government bonds. While the DEX currently includes a 28% corporate bond allocation, a separate corporate bond allocation will enable a plan to overweight its corporate bond allocation.
• Mortgages – A mortgage fund comprises diversified commercial mortgages. Since most Canadian mortgages have a term of five years or less, a mortgage fund will have a much shorter duration than the DEX. Since mortgages are not as liquid as bonds, they tend to compensate investors with a higher yield than traditional bonds.
These strategies involve investing in bonds with higher interest payments.
• High-yield bonds – A high-yield bond fund invests in corporate bonds that are rated below investment grade (BBB). These bonds are not included in the DEX, which is restricted to investmentgrade issues. In exchange for assuming a higher risk of default, investors are compensated with a significantly higher interest rate. Despite the higher default risk, the default rate among U.S. highyield bonds in 2009—the depths of the credit crisis—was only 10% and dropped back below 2% in 2010 and 2011. Another benefit to high-yield bonds in a rising interest rate environment is that they tend to have a very short duration. A high-yield bond fund could focus on Canadian, U.S. or globally diversified high-yield bonds.
• Global bonds – A global bond fund comprises non-Canadian government and corporate bonds. A global bond mandate will allow an investment manager to find bonds in countries that better compensate investors for assuming investment risk. For example, in 2008 and 2009, when a flight to quality reduced Canadian and U.S. federal bond yields to extremely low levels, global bond managers were able to find countries with higher yields to generously compensate them for the risks they were assuming. Likewise, a global bond manager can compare companies in similar industries around the world and identify mispriced bonds that are overcompensating investors for the risks assumed. Global bond funds have historically offered a higher yield than comparable Canadian universe bond mandates.
• Emerging market debt (EMD) – EMD funds comprise government and corporate debt in emerging markets. Despite the improving financial positions of many emerging market economies—which have lower government debt levels than many developed countries and improving credit ratings—the risk premium demanded from investors is quite a bit higher than that demanded from investors in developed economies. An EMD mandate will allow an investment manager to find bonds in emerging market countries that provide access to faster-growing economies and improved government finances (compared to many western economies). EMD portfolios have historically offered a higher yield than comparable Canadian universe bond mandates. However, a significant percentage of the bonds will be rated below investment grade. Fixed Income Alternatives These strategies involve investing in other asset classes that deliver regular income, such as bonds, with less sensitivity to interest rate movements.
• Real estate – A typical real estate fund will allow a pension fund to invest in a diversified portfolio of income-producing commercial and industrial real estate. As with bonds, real estate portfolios provide yield (through rental income), which will make up a large percentage of the total return. Real estate returns will also compensate investors through capital gains, which have more equity-like characteristics, so a significant portion of their return comes from capital gains, rather than from regular interest payments from bonds. At the same time, real estate investments are priced to compensate members for the reduced liquidity of individual properties.
• Infrastructure – A typical infrastructure fund will enable a pension fund to invest in a diversified portfolio of incomeproducing infrastructure projects. Infrastructure funds offer opportunities to invest in public infrastructure such as transportation networks, health and education facilities, communications networks, and water and energy distribution systems. These essential services projects require long-term investors, as liquidity may be restricted and the investments may require initial development periods in which the return is limited. However, over the long term, these investments produce higher yields than even real estate portfolios, with low volatility levels. Infrastructure investments are particularly attractive to pension investors because of their long-term, stable cash flows, which are often indexed to inflation levels.
The challenge for small to mid-size funds is getting access to these alternative investment strategies. Some of the key issues that smaller plans face include the following:
• Higher cost structures – Most investment products offer a tiered fee schedule that reduces fees as the asset size grows. This results in a lower net-of-fee performance for smaller plans relative to their larger counterparts.
• Smaller investment opportunity set – Minimum asset size limits have prevented smaller plans from accessing certain asset classes, such as real estate and infrastructure, whose risk and return characteristics can enhance portfolio performance.
• Limited resources – Limited budgets for monitoring and oversight often force smaller plans to use easier-to-manage investment structures, limiting the number of managers and asset classes employed.
Many large plans will limit alternative investment allocations to 10% to 15% of the portfolio. For a smaller pension fund with assets of about $50 million, this would represent an alternatives budget of roughly $5 million to $7.5 million. This limited budget might preclude the use of many alternative asset classes or entirely eliminate the opportunity to diversify across multiple strategies, since many of these individual strategies require a minimum commitment of $5 million to $10 million. Canadian real estate may be the exception, where some managers will accept amounts below $5 million. But despite the challenges of scale, there are ways for smaller plans to use some of these strategies to better protect their portfolios in the face of low and rising bond yields. Consider the following approaches.
• Shortening portfolio duration – Most traditional bond managers can adjust the duration of a traditional fixed income portfolio by increasing the allocation to a short-term bond or money market fund. Some managers may offer a pooled corporate bond fund, which enables a smaller pension fund to increase the corporate bond weighting in its fixed income allocation. These options will allow a pooled fund investor to shorten the bond duration and marginally increase the portfolio yield above that of a regular pooled universe bond mandate.
• Exchange-traded funds (ETFs) – ETFs represent a basket of securities that tracks an index. These funds are an inexpensive way for smaller plans to get exposure to asset classes such as real estate and infrastructure. Real estate ETFs can provide exposure to a range of real estate investment trusts representing large segments of the real estate market. Infrastructure ETFs provide exposure to a broad range of companies, with a significant exposure to infrastructure projects.
The primary disadvantage to ETFs is that they do not always closely track the price movements in the underlying asset because their price movements may be influenced by sentiment toward the underlying management teams of the constituent corporations. They are listed like stocks and continuously valued, so they will experience higher volatility than the underlying asset—and, in certain cases, the ETF may incorporate high levels of leverage.
• Core-plus bond strategies – These strategies are similar to core bond strategies in that their investments are mainly within the DEX Universe Bond Index. However, they allow the bond manager to opportunistically invest a portion of the portfolio (usually about 20% to 25%) in a diversified range of alternative bond strategies that could include high-yield bonds, mortgages, foreign bonds and EMD. Core-plus bond strategies enable smaller plans to access a broad range of yield-enhancement and duration strategies within one fund.
• Leveraging alternatives – As expertise in and exposure to these newer asset classes grow, investment consulting firms are increasing their ability to leverage a broader set of alternative fixed income products for smaller pension funds. In some cases, these opportunities are a result of increasing knowledge and exposure to key managers in this space. In other cases, they result from using shared alternative structures across a larger client base.
Pension plans that continue to rely on fixed income investments will need to more actively manage these allocations in order to maximize fixed income returns going forward. For smaller plans, this represents a large challenge, due to their limited scale and resources. However, with a little diligence and creativity, they may be able to replicate many of the same strategies employed by their larger counterparts. Using portfolio duration and yield-enhancement tools to maximize returns from their fixed income portfolios will give smaller plans that home field advantage.
Colin Ripsman is a principal with Eckler Ltd.
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