With fixed income yields at historic lows and no clear sign of improvement in sight, pension plan sponsors are facing a challenging investment environment.
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CANADIAN INVESTMENT REVIEW
Most are required to make large allocations to fixed income. To make matters more complicated, the traditional fixed income instruments on which plan sponsors could rely on in past cycles do not appear well-suited to the investment world of 2021.
Against the backdrop of this bleak fiscal landscape, the Canadian Investment Review organized a conversation between investors with specialized expertise across the fixed income spectrum. From discussing the distortions caused by the overwhelming use of quantitative easing during the coronavirus pandemic to the risks and opportunities of new, alternative approaches to risk management, diversification and liability matching, our panel of experts did not hold back on sharing their thoughts on the future of fixed income investing.
GIDEON SCANLON: How have fixed income markets changed from before COVID-19 hit until now?
DUSTIN REID: It’s obviously been a fascinating time for all markets — particularly the fixed income space. Clearly there has been massive intervention in the market from the government.
In terms of how markets are now going forward, clearly before we had the global financial crisis in 2008–2009, and we saw governments get involved in markets, but I would say the reaction function was quite a bit slower and definitely not at the same depth we see now.
Now we see a different reaction function where the Fed particularly, but also other central banks, come in from a monetary perspective and get involved quickly and at a significant level. That, obviously, happened here domestically with the Bank of Canada as well; we saw it with the European Central Bank and the other major central banks.
Then, of course, there has been the fiscal side where sometimes it takes a little longer to get together — but most governments got on side. We all know what happened under the Trump administration; they were able to get a number of packages together. When you look at the notional amount of the first package, it looks almost comical in size compared to the Biden package from earlier this year.
Obviously, there has been massive amounts of stimulus across the fiscal and monetary spectrum. That’s having an effect on fixed income markets because markets are distorted; however, you want to define that.
MICHELLE RUSSELL-DOWE: This is one of the fastest cycles that we have ever seen. Early-cycle timing, mid-cycle conditions and late-cycle valuations seem an apt description of where we are.
Current fixed income return prospects are asymmetric. Returns have been pulled forward in terms of asset value. With low rates and lower credit spreads, risk from interest rate changes and the credit spread changes are also asymmetric.
Policy support seems to have interjected moral hazard into the markets, as many deem it easy to take risk with the government support providing a floor.
Has the monetary policy made a credit cycle impossible? That remains to be seen — that would be the one inference you could draw. That is a concern.
If you’re relating the market today to where we were right before the pandemic, it is not all that different — never have we been paid less for risk than today, and never have the risks been higher or more asymmetric.
“This is one of the fastest cycles that we have ever seen. Early-cycle timing, mid-cycle conditions and late-cycle valuations seem an apt description of where we are.”
- MICHELLE RUSSELL-DOWE
GIDEON SCANLON: How have quantitative easing and other monetary policy developments changed bond markets?
DUSTIN REID: Without that monetary and fiscal stimulus, where would yield curves be? What would be their shapes? Not only in the United States and Canada, but globally. That’s a significant driver in terms of how things have changed.
If there is another crisis, what does the reaction function look like going forward? I would guess more like 2020 than 2008. It is going to be quicker, and we’re not going wait and guess — we’re going to come in. That changes the dynamic for all markets in this space, particularly fixed income markets.
If we see something on the horizon, how will it get priced in? How quickly? You may not have to wait as long. The period we had from late February last year where it was clearly a risk-off environment and markets were trading as such, maybe it is not as much of a risk-off environment. People think the reaction function is going to be different, quicker and deeper. Those bouts of pro-longed risk-off we saw in equities and fixed income were significant moves.
I think a blueprint is there for the next one — whenever that is. The untold story of this one is of central banks and governments that have massive balance sheets and have accumulated huge debt. So the second half of the story – Act 2 – hasn’t played out yet. How are we going to unwind that, and how are markets going to take that? What does it mean going forward? We’ve had an attempt at an unwind before — most recently in 2008.
AMAR REGANTI: I think we have to expectglobal central banks to be almost permanent players in fixed income markets going forward. I don’t see a path back to a world where balance sheets shrink or normalize or come back to a place where the central banks are not active market participants.
The reason for this is twofold. First, fixed income markets over the past decade or two have evolved to become extraordinarily fragile from a market-microstructure perspective. They are more vulnerable to shocks and dislocations than in the past. Private capital markets now often have a difficult time adjusting to these exogenous shocks and events, as we saw with the rapid onset of COVID-19 in March 2020.
Central banks, especially the U.S. Federal Reserve, have their dual mandates of maintaining relatively low inflation and strong employment. There is a realization among policymakers that you can’t achieve these goals if financial conditions are poor. Some would attribute this to the “financialization” of developed economies — call it what you want, it is true. To some degree, you almost have to expect some type of policymaking initiative to keep those markets stabilized.
“If there is another crisis, what does the reaction function look like going forward? I would guess more like 2020 than 2008. It is going to be quicker, and we’re not going wait and guess — we’re going to come in. That changes the dynamic for all markets in this space, particularly fixed income markets.”
- DUSTIN REID
The second thing worth noting is that we used to all watch central bank policy and often over-looked fiscal policy. The 800-pound gorilla is now fiscal policy, which has largely upended the dominant role of monetary policy in economies.
It is now consensus that monetary policy can’t do it all. There’s going to be substantial fiscal authority, and if it can’t commit, we could almost return to the secular, stagnant world that existed prior to the pandemic epitomized by the low level of absolute interest rates and flat yield curves.
KONSTANTIN BOEHMER: We’ve become detached from fundamentals. Crises are also market-clearing events. Companies fail when fragilities are exposed, and that creates the fertile seeding for the recovery when labour, rent, equipment, et cetera are plentiful and cheap.
With the quick response from different players across the globe to provide support for companies and countries, we didn’t have those market-clearing events. That is facilitating the creation of zombie companies and zombie countries — not solving anything, just creating a bigger problem for the next time.
You can see tons of zombie companies across the globe that should not exist — from a macro perspective and taking the suffering out of the equation, it’s not such a bad thing if companies default on their obligations if the economics do not work anymore.
Mispricing is another theme. We are detached from fundamentals. We are all taught to pay attention to the fundamentals. What is priced in the market are huge distortions that are making our lives as portfolio managers and investors a little more challenging — it is now not really about those fundamental pieces.
“The second thing worth noting is that we used to all watch central bank policy and often overlooked fiscal policy. The 800-pound gorilla is now fiscal policy, which has largely upended the dominant role of monetary policy in economies.”
- AMAR REGANTI
GIDEON SCANLON: What’s your outlook for interest rates and inflation? With your outlook in mind, are there specific types of fixed income you think offer the most promise right now? Why?
AMAR REGANTI: At this point, if you look at one- and two-year inflation breakeven rates — which are at about two-and-three-quarters — they’re a bit lower than the surveyed consensus for one- and two-year inflation expectations. I think inflation is actually going to run a little hotter than what the market is implying over the next two years.
Does it continue to run higher beyond that? I think it is a heavy lift to get there, but I think for the first time in a long while, there are some viable paths toward stickier inflation.
If the traditional narrative around the role of monetary policy changes with ongoing and substantially greater fiscal policy, we could even see a longer-term shift — but that isn’t my base case. It’s a secondary case whose outcome has grown in probability — and, frankly, I believe it is at its highest likelihood than it has been in the last couple of decades.
DUSTIN REID: I think that when we talk about policy rates, we need to normalize from here. We can’t be at this effective zero bound forever. Even under Fed Chairman Jerome Powell, who has been much more focused on survey-based data, I think it’s recognized that lower inflation expectations have become ingrained a bit more in society.
I think the Fed is concerned about that. There’s obviously a legal discussion about whether the Fed can go negative. It is worried about that negative feedback loop. Other central banks, like in Canada, look at what’s happing in Europe and Japan and do not want to embark on that negative feedback loop as it may pertain to expectations.
From a yield-curve-market expectation, we’re heading higher — nominal GDP growth in the United States is headed to 10 per cent. Much of the yield curve looks mispriced. It is tough to justify 10s at 1.30 per cent when you have nominal GDP running roughly at 10 per cent. You see whatis happening in terms of prices — the National Federation of Independent Business Economic Trends Survey and things like it suggest it is very difficult to find skilled labour, firms expect to pay more, inventory ratios are way down, input prices are rising significantly and obviously oil has been trending above the top of the range a lot of people expected to hold.
You have those inputs for cost price pressures — from a rates perspective, it is going to be constructive for rates higher here in the coming quarters as we head into later 2021 and early 2022.
GIDEON SCANLON: Many Canadians still have a home bias in fixed income. Do you think that’s starting to change. Why or why not?
KONSTANTIN BOEHMER: For sure there is a home bias in fixed income, and we do see it start-ing to change. Having said that, I also don’t mind that there is some moderate form of home bias.
I look at it from the perspective of insurance. You typically want to have insurance on something that is directly covering the risk that you are facing — within your life-portfolio of job, house, investments — Canadian fixed income can play that role really well.
While Canada is part of a global and connected world, there will always be some instances where Canada will have an outsized response, positive or negative, to world events. For example, there are bigger risks specifically related to commodity prices in Canada.
During an episode where some things hit Canada harder, you probably want to have insurance that works specifically for that — you want to have an insurance policy directly tied to that. If commodity prices are taking a severe hit, the Bank of Canada will be much quicker to react and therefore the Canadian fixed income space will likely perform better than other global fixed income markets.
There is a space for Canadian fixed income within Canadian portfolios and there should be
a home bias. Having said that, it is easier to pick opportunities when your universe is larger. You have to venture out if you want to achieve sustain-able absolute returns because if you are captured in the Canadian space, you will have trouble hiding from overall market trends.
There’s a good case to be made in diversifying and looking into global opportunities, but a significant chunk should also be in your home market — particularly in fixed income.
“With the quick response from different players across the globe to provide support for companies and countries, we didn’t have those market-clearing events. That is facilitating the creation of zombie companies and zombie countries — not solving anything, just creating a bigger problem for the next time.”
- KONSTANTIN BOEHMER
ALAN MATIJAS: Canadian institutional invest-ors of all sizes are much further along in their global diversification journey than was the case even five years ago, but we continue to see an increasing appetite for non-domestic fixed income exposure from our client base. For example, when I reflect on our book of business in Canada 10 years ago, the percentage of our pension assets in non-domestic fixed income was very low. Now, it is significant — almost half of our total Canadian assets.
There are good reasons to have a domestic bias in your fixed income portfolio, particularly for risk-mitigating, liability-matching purposes. Certainly more so than having a domestic equity bias — it’s just a question of how to size it. For plan sponsors that haven’t taken the first steps toward globalizing their fixed income portfolio, there are many reasons to consider doing so today. It begins by understanding which fixed income allocations are playing a primarily return-seeking role versus a risk-mitigating or liability-matching one.
“For plan sponsors that haven’t taken the first steps toward globalizing their fixed income portfolio, there are many reasons to consider doing so today. It begins by understanding which fixed income allocations are playing a primarily return-seeking role versus a risk-mitigating or liability-matching one.”
- ALAN MATIJAS
KARL BOURASSA: Historically, pension plans have focused more on Canadian fixed income partly because it has been used as a way to hedge their liabilities. Generally, pension plans have looked at traditional asset classes as discrete types of investments to further specific functions — equities for returns and fixed income as a ballast. I’d argue that we slowly started moving away from that approach years ago, and this trend is gaining momentum.
GIDEON SCANLON: What’s the biggest fixed income challenge plan sponsors will face in the future?
KARL BOURASSA: The 40-year bull market in fixed income is dead — or at least close to it and coming to a tail end, so we’re facing the risk of higher sustained inflation. For the first time in
a generation, portfolio managers will be facing rising interest rates or at least non-declining ones.
In such a situation, I’d posit that pension plans need to start looking at hybrid types of investments that do not fit neatly in the categories used in the past — to wit, fixed income instruments must also be seen as a tool to achieve return targets and mitigate risk in a very different mar-ket environment. It’s kind of like having to use a hybrid bike on your next trek when you have faced nothing but smooth blacktop in your past 40 years of riding. To the layperson, it may seem like a simple idea to implement. But if you take biking seriously, it may sound like heresy.
The road ahead will be different from that of the past and will need to look at alternative fixed income investments that will help pension plans further their goals — and these are not necessarily readily available in the Canadian markets. As you face increasing asymmetry in the fixed income markets in general, a larger investment universe will be necessary to achieve your goals.
“The 40-year bull market in fixed income is dead — or at least close to it and coming to a tail end, so we’re facing the risk of higher sustained inflation. For the first time in a generation, portfolio managers will be facing rising interest rates or at least non-declining ones.”
- KARL BOURASSA
GIDEON SCANLON: What would be your advice to pension plan sponsors that want to get the most return out of their fixed income portfolios while also using them for risk management purposes?
MICHELLE RUSSELL-DOWE: In order to give ad-vice to investors or plans, you have to be mindful of one question. To what end?
What is the purpose of an investment within a broad portfolio allocation? Once you understand that objective, an outcome-oriented solution can be recommended. So, in examining today’s challenges for fixed income investors, the biggest challenge for return seekers is where they get their returns in an environment where yields are very close to zero.
If investors are using fixed income as ballast or a hedge to other risk-oriented investments, will the ballast work as it has in the past or will the correlations be different going forward?
ALAN MATIJAS: I think the traditional approach of relying on high-quality domestic bond indices to meet all your fixed income investment object-ives is probably not a good place to start.
Many of the attractive opportunities discussed today are simply not available to investors relying exclusively on traditional high-quality domestic bond indices to define their opportunity set. These indices generally represent a narrow credit opportunity set, have a high degree of concentration in provincial credits, and are significantly underexposed to structured debt and bank loans.
In my view, those are good reasons for many investors to rethink how to best position their portfolios to tap into a wider net of global fixed income opportunities.
GIDEON SCANLON: Plan sponsors need to be thinking about the role fixed income should play — but what can they do to address some of the challenges and realities in the fixed income space today?
AMAR REGANTI: You want to provide fixed income managers with flexibility to take advantage of compelling opportunities as they appear. That could be a global unconstrained bond fund, for example, or it could be a multi-asset credit portfolio. When you think about how quickly and unexpectedly opportunities can present them-selves, you are at a real disadvantage if you rely on the glacial pace of a strategic asset allocation review to allocate capital. You’re likely to miss out with the latter approach.
GIDEON SCANLON: What role can absolute return in fixed income play in a pension portfolio?
KONSTANTIN BOEHMER: As a fixed income guy, I have looked closely into the private-debt space; it is an interesting space without a doubt. You can earn higher yields and you are supposed to clip that in a more consistent manner. But, of course, there’s a risk that something could go wrong and the risk of a catch-up in prices. When you are in an illiquid market, you don’t see those daily price movements that you see in public markets — but a lot of that movement also happens in the private space, it is just hidden until you need your money back.
Nonetheless, it is a great tool in the toolkit — we also use it selectively in many of our funds — with the right partners and in the right niche. Another area in the alternative space that is important for absolute return is leveraged products. One fund we have that is trying to answer the absolute returnquestion in the alternative fixed income space is a credit absolute return fund.
In there we have multiple distinct strategies that are optimized to make the best use of the flexibility to use leverage.
We have an alpha long-only credit strategy; a long-short, high-yield piece; and also some quant strategies. Beta is often what drives performance. If we like the market, we use that leverage. If we don’t, we limit the exposure we have. Adding that flexibility to the expanded toolkit makes it an interesting area for plan sponsors to look at, but sizing matters. Smaller pension plans maybe have more room to investigate the space; the bigger ones are already to some extend invested.
MICHELLE RUSSELL-DOWE: For return seekers, it is a tough market. We believe investors need to think about more risks not more risk.
That’s a veiled diversification answer, but it is incredibly important at a time like today. The policy support has reduced volatility; the central banks seem to be in the business of dampening volatility, and with it reducing risk premium.
So, at a time when risk premiums are not all that great to start with, it makes sense to diversify these risks earning return, not just from credit risk premium, but also considering prepayment risk, liquidity risk and complexity premiums.
As a result, I think plans will be challenged to look at their liquidity. What are their real needs for liquidity and how do they use liquidity premium — in other words, do they have enough or too much?
That is another way to evaluate the use of the risk premium where you are monetizing inefficiency or alpha or barriers-to-entry, so you are not just yield hunting.
KARL BOURASSA: I would suggest that brings us to the real challenge that plan sponsors are facing. As a plan sponsor, you are building in assumptions and expectations in terms of returns that are based on benchmark returns; therefore, the more flexibility you give your manager versus your goals, the more active risk you are taking.
Thus, you have to balance policy risk versus asset allocation, or in this case specifically, active risk. Depending on the size of a plan, one way to address this is to have a specific strategic allocation to alternative fixed income, thus factoring in different return expectations for each fixed income sleeve.
Based on what this group of investment professionals are saying today at this roundtable, there’s a case to be made that you need to go outside what is generally considered traditional fixed income to meet return expectations, and in doing so you are looking to harvest a certain premium, whether it’s liquidity, complexity or otherwise. Just like in any other case, you expect that premium is going to differ in size at different moments in the economic cycle. In the case of dedicated allocations to different parts of alternative FI, it is incumbent on the PM to manage according to exact alpha versus a situation where a plan allocates to an unconstrained fixed income product, which will give the manager the flexibility to go in and out of different markets depending on opportunities.
To be clear, the advice would be, if you can afford it, have a strategic allocation to different buckets of alternative fixed income where you see the potential for premium harvesting.
GIDEON SCANLON: Let’s talk about alternative fixed income — what strategies are plan sponsors looking to in order to manage their fixed income portfolios in these challenging times?
AMAR REGANTI: First of all, I think the term “alternative” in fixed income is highly problematic. There’s such a heterogeneity in alternative fixed income and lots of good ideas within that wide universe, so I’d be careful about using the term “alternative” too freely.
In certain parts of the credit cycle, I am a proponent of looking at long-short credit because I think its characteristics can give you less directional beta, potentially attractive returns and less volatility. And, overall, it is not a universe that everyone can just “jump into,” making it less efficient. You have to understand not just the credit fundamentals in this space, but also the financing and the trading dynamics behind it. You need to know the “plumbing,” so to speak, and it takes a lot of work to do that.
So, good long-short credit strategies can be very additive, particularly if you are uncomfortable adding on outright credit beta. I do think there is a place for this type of allocation in many client portfolios. The challenge, of course, is that you have to find an investment manager who is highly skilled and experienced in this area and who has ample capacity to do it effectively.
GIDEON SCANLON: What are the risks of using alternative fixed income?
KONSTANTIN BOEHMER: Fragile assets are going down in value when you have a volatility event — that would include equities and in general risky assets. You have anti-fragile assets that go up in value when you have a negative volatility event — that’s your core fixed income. You can also put in some currencies in that category, the U.S. dollar, the Japanese yen or the Swiss franc. In order to have a well-rounded portfolio, you need to have fragile and anti-fragile assets in there.
You cannot have all strikers on a soccer team. You need a goalkeeper, you need defence and midfielders as well. Sure, in some games, it will be enough to just have strikers — but to win the championship and for the longer run, you need that well-balanced team. I think fixed income plays a role — there aren’t many anti-fragile assets around that you can sprinkle into your portfolio.
Things that are risky or illiquid will have that fragile component. They will all suffer at the same time. There’s a role, and you need to look at it from your own portfolio perspective to see how much risk you can take where, and that reaching for yield. If you say you can’t get it from government bonds, you go into credit, and if not credit, private credit — that is a risk.
I see a lot of potential in the alternative space, but one needs to be very mindful of the overall takes — make sure your team isn’t made entirely of strikers. Proper due diligence, especially when you go into something a little bit more alternative, is absolutely key — not only on manager performance but also on the investment process, the operations, other investors, et cetera.■
Fixed Income Roundtable Sponsors
Mackenzie Investments, founded in 1967, is a leading Canadian global asset manager, headquartered in Toronto with international investment teams in Boston, Dublin and Hong Kong. As part of IGM Financial Inc., a subsidiary of Power Corporation with a history dating back to 1925, Mackenzie benefits from the financial stability of a deep corporate structure while maintaining a boutique investment management profile.
Our distinct and experienced investment teams offer both fundamental and quantitative approaches with expertise across traditional and non-traditional asset classes, including equities, alternatives, currency and multi-asset strategies.
We provide investment management services to pension plans, consultants, foundations and other institutions, building trusting relationships that seek to understand client perspectives. We are committed to delivering strong investment performance and offering innovative, relevant solutions to our clients by drawing on the experience gained through over 50 years in the investment management business.
Schroders is a global asset management firm with an over 200-year history and professionals operating in 37 locations around the world. Our firm provides a full range of actively managed domestic, international and emerging market investment products from equities to fixed income to multi-asset and alternatives. Our structure and investment philosophy are focused on strengthening the partnership with our clients over the long term. We offer innovative solutions by intelligently challenging global market practices in anticipation of what’s ahead. Schroders is deeply committed to its sustainable investment philosophy and is seeking to make a wider contribution to society.
Schroders has been managing assets for Canadian clients since 1994 with C$1,000.3 billion in AUM globally as of December 31, 2020.
Tracing our history to 1928, Wellington Management is one of the largest independent investment management firms in the world. We are a private firm whose sole business is investment management, and we serve as investment adviser for institutional clients in over 60 countries. Our most distinctive strength is our commitment to rigorous, proprietary research — the foundation upon which
our investment approaches are built. Our commitment to investment excellence is evidenced by our significant presence and long-term track record in nearly all sectors of the global securities markets.
We have been managing Canadian client assets since 1979. As of March 31, 2021, we manage over C$33.2 billion in fixed income, equity and alternative investment strategies for a distinguished group of over 40 clients across Canada. Public and corporate pensions, mutual fund sponsors, insurance entities, endowments, foundations and family offices have benefitted from our global presence and breadth of expertise