With renewed volatility prompting money managers back on their toes, equity markets have been leading investment industry discussions over the past few quarters.
Against this backdrop, how is fixed income, the other fundamental building block of defined benefit pension portfolios, faring?
For David Lafferty, senior vice-president and chief market strategist at Natixis Investment Managers, the question is whether global growth is decelerating towards a more normalized level, or whether things are heading for a dip that qualifies as a global recession. Of all the potential scenarios for the next year, he says, a recession is the most important to watch for because markets aren’t priced for it.
“I would put the probability of a U.S. or global recession beginning in 2019 . . . at about 30 per cent. That’s a little bit higher than some people, but that still means there’s a 70 per cent probability that we think we’re slowing but not going into recession.”
Self-fulfilling yield curve
With that probability, the bond market appears to be overreacting, says Lafferty. In March, the yield curve on the 10-year U.S. Treasury note inverted, a situation where yield on short-term debt instruments is higher than long-term ones. The upshot, he adds, is that markets seem to be pricing in rate cuts from the U.S. Federal Reserve, when it hasn’t even hinted, much less announced, that any are on the horizon.
“I’m not losing any sleep over the yield curve yet, but ask me in a couple of months,” says Lafferty.
In North America, Europe and Japan, consumers are still faring reasonably well. Unemployment is low, job gains are solid, wages are rising and debt burdens aren’t excessive, partially because interest rates are so low, he says, noting it’s difficult to imagine a U.S. recession without more headwinds for consumers.
As in the U.S., Canada’s bonds markets are getting ahead of themselves, with markets pricing in a potential rate cut from the Bank of Canada, says Greg Nott, chief investment officer at Russell Investments Canada Ltd. “We think it’s unlikely that we’ll see a rate cut this year. And if the market does eventually come around to that view, we could see some upward pressure on bond yields.”
However, the picture isn’t completely rosy, since risk around lower-rated bonds is always something to watch during the late stages of the business cycle, says Lisa Hornby, portfolio manager at Schroders Investment Management Ltd. She notes that environment, coupled with a yield-curve inversion, could cause some tension in fixed income markets. “A yield curve inversion does have some implications for how lending continues,” says Hornby. “You have less incentive as a bank or as an individual to lend for [a] longer term, when you can achieve the same yield for a shorter term. So that does have a slowing effect on the economy. In some ways, the inverted yield curve is self-fulfilling in terms of a recession.”
As pension plans move away from equities, high-quality fixed income is heating up, says Lafferty, pointing to recent Natixis data that found the only fixed income category where fewer investors were buying than selling was high-yield instruments.
While retail investors go with the flow, institutional investors are beginning to shift allocations in preparation for lower growth, he says.
And with the sell-off at the end of 2018 notwithstanding, a decade of equity gains has put a lot of pension plans in a good place for de-risking their portfolios, says Nott. “We have seen a move to longer duration, or in some cases ultra-long duration, 20-year plus duration.”
He’s seen plans using levered long-duration products that can provide a 30- or 40-year duration, meaning they don’t need to allocate as much capital to achieve a duration match, leaving more capital available to invest in other asset classes.
From a return perspective, a more muted outlook for equity gains makes fixed income more attractive, says Philip Petursson, chief investment strategist at Manulife Investment Management. “If we think equities have a return profile in the mid-single digits and bonds aren’t that far off of that, then when you compare the downside risk of each, it is swaying towards fixed income for the next 12 to 24 months, perhaps.”
The Ontario Teachers’ Pension Plan has followed this general trend, increasing its overall portfolio allocation to fixed income from 22 to 31 per cent in 2018, the highest allocation of any of its asset classes as of year-end. In turn, it shifted its equity position down slightly, from 19 to 17 per cent.
“Fixed income performs a very important role and that is to protect the portfolio if there is a growth shock to the downside, or an inflation shock to the downside or both,” says Ziad Hindo, chief investment officer at Ontario Teachers’.
Stress testing and analysis over the last two years led the pension fund to conclude it needed more fixed income to cushion the potential impacts of a serious economic downturn. Once the team reached this conclusion, it turned its attention to how to make new acquisitions, says Hindo, noting timing was key.
“We wanted to make sure that we were sensitive to entry level, so we gave that a lot of thought, but also, how we diversify away from domestic bonds. It was, perhaps, a bit timely, considering that the Fed started hiking rates and the Bank of Canada started hiking rates. That monetary tightening gave us the opportunity, given that we thought we needed more fixed income in the portfolio.”
Widening the net
While pension plans have done an excellent job geographically diversifying their equity exposure, the same isn’t true for fixed income, says Nott, though he notes that’s starting to change.
“I do think they’re looking for more global [equity] because the Canadian market is fairly narrow. On the credit side of things, it’s dominated by the financials; you don’t get as much diversification there. There is very little securitized product, very little structured credit. If you are looking for duration or taking interest rate risk, in Canada it’s very binary. There are a lot of other countries out there [where], even on a hedged basis, the yields are more attractive. So we’re encouraging our clients to look more globally.”
About 15 years ago, Canadian defined benefit plans’ allocations to fixed income were mainly characterized by how unremarkable they were, says Petursson. “They had very plain, vanilla, long government bonds and that was about it.”
Fast forward to today and Canadian plans, as well as pensions around the world, are gravitating towards bond portfolios that are diverse in both sector and geography. And notably, their strategies are less often tied to a particular benchmark, he says.
“It’s a function of ‘go where the opportunity exists, regardless of geographic area,’” says Petursson. So far in 2019, asset managers are especially bullish on local currency emerging market debt, according to Russell Investments’ latest fixed income survey. Three-quarters (73 per cent) of managers said they expect a six per cent or better return from these assets over the next 12 months, compared with 47 per cent who said the same last year.
As for specific local currencies, the Mexican peso has lost its spot as the darling as manager attention shifts to the Brazilian real. The Russell Investments’ survey found 28 per cent of managers considered it the most attractive local currency for emerging market debt.
However, Invesco’s 2019 fixed income survey highlighted China’s bond market as one to watch as asset allocation to the region has been trending higher. About a third (37 per cent) of defined benefit plans surveyed indicated they have an allocation to Chinese fixed income, while 40 per cent of defined contribution plans said the same.
But foreign investment in China’s bond market is still very new. At the end of 2017, investments from outside the country sat at just 1.6 per cent, according to Jean-Charles Sambor, deputy head of emerging market fixed income at BNP Paribas Asset Management, in a webcast in April. While it’s on the rise, this number only reached 2.3 per cent at the end of 2018. However, the increase is still enough to convince Sambor that China’s bond market is finally opening up.
“We’re not denying that it’s going to be a pretty volatile journey,” he said. “But we think all the stars are aligned in both the onshore and offshore markets.”
Martha Porado is an associate editor at Benefits Canada.