Central banks slowing their quantitative easing policies and economic improvements off the back of wide-scale vaccination efforts should both provide bond yields with a modest boost in 2021.
But that won’t give defined benefit pension plan sponsors much relief. “You hear the phrase ‘low for long’ and I would agree we’re in an extended period of low rates, but I would add a little asterisk,” said Avery Shenfeld, managing director and chief economist of CIBC Capital Markets, during the Canadian Investment Review’s Defined Benefit Investment Forum in December.
“Low for long, but not as low as we’ve seen. . . . It may be, for example, that at the end of 2021 we still have 10-year rates not above 1.5 per cent. That’s very low by historic standards, but not as low as they are right now.”
That scenario presents a substantial challenge for DB plans staring down a decade of “pretty miserable” fixed-income returns, he said. Shenfeld and his colleagues conducted a simulation of a portfolio of two-, five-, 10- and 30-year Canadian government bonds, looking at projected returns up to 2030.
“Over the next decade, the annual rate of return . . . is less than one per cent a year, and in the first few years we actually have some negative returns, where the price movement as rates rise is more than a running yield,” he said, noting this return would be more than a percentage point below inflation, which is projected to hover around the two per cent mark for the medium term, with possible slight upward fluctuations as gasoline or airline ticket prices rise on the recovery.
“The challenge for a pension plan is, how do you counterbalance that without taking undue risk?” he said. “The other solution to this — the painful one — is you need more money going into the pension fund in order to reach a given target for income. . . . There are no easy answers to how you manage a defined benefit pension when you’re starting from such low yields and you don’t have the prospect then of great capital gains on the bond portfolio.”
Real estate may also face challenges with asset prices having increased when bond yields fell, reducing investors’ expected cap rates. The coronavirus pandemic also introduced additional questions about what cash flows investors can reasonably expect from renting those units. Shenfeld said investors should turn to the concept of revealed preference, or what people and businesses were choosing to do when they had the opportunity to choose, to address these concerns.
“Right now we don’t have the opportunity to choose in many cases whether we’re going to work in an office or not . . . but we did as recently as 2019,” he said. “For those who think that we’re all going to stay working at home, I’ll remind you that Zoom was not an overnight success, that this technology has been around for six years and we could have chosen to all work at home but we didn’t.”
Shenfeld said he’s more optimistic on the future of office real estate because of the economic benefits of bringing people together — such as collaboration and training new employees — but is more concerned about real estate designed for retail.
“Even before this pandemic there was a declining market share for in-store sales and a gain in market share for online retailing,” he said. “We know people are ordering groceries delivered for fear of walking into the store, but they would much rather pick their own tomatoes. . . . They’d much rather try on that pair of boots to see if it fits or looks good. So I think that people will return to stores and stores will therefore regain some of the market share, but not all.”
Looking at 2021, Shenfeld said Canada will struggle to make headway on the unemployment rate in the next couple of quarters, and speculated it could average around eight per cent through most of the year as hard-hit sectors like travel and entertainment struggle to recover from the pandemic.
However, he’s optimistic mass vaccination will push five per cent growth in gross domestic product for Canada in 2022 and reduce unemployment significantly. “[I’m] pessimistic a little bit in the near term, but there is a light at the end of the tunnel — and it’s not, as the joke goes, a freight train coming to hit us. It’s actually the men and women in white with the vaccines in the vials that are going to be delivering that employment boost to Canada.”