While the Bank of Canada had long talked down the idea of raising interest rates any time soon, the sentiment changed last month when it announced the economy was now strong enough to handle an increase. The move followed the U.S. Federal Reserve’s decision to raise its key interest rate for the third time in six months.
While some investors will see upsides from increased rates, bigger doesn’t always mean better when it comes to fixed-income returns. What’s better for some investors — higher bond yields — can have downsides for pension plans. When yields rise, plans fear they won’t get the decent returns from the bond markets that they’ve seen during the years of very low interest rates.
The issue came to the fore during the latter part of 2016, when bond yields began to rise amid political uncertainty. And now that the Bank of Canada has made a move, investors are waiting to see if the July increase signals a trend towards significantly higher rates.
“There have been concerns about rising interest rates for a long time,” says Chris Kresic, portfolio manager for fixed income at Jarislowsky Fraser Ltd. “I remember, in the late ’90s, a bond manager saying he wanted to become an equity manager because the bond market was done. That was 20 years ago.”
Kresic argues that “just because rates are at 5,000-year lows, [that] doesn’t mean they’re going to rise necessarily in the next three to five years. The fundamentals of what drives interest rates — inflation and growth — still don’t look at that problematic for interest rates.”
Tom O’Gorman, director of fixed income with Franklin Bissett Investment Management, concurs. “If you take away January to June of 2016, which was the oil crash, and Brexit, the 10-year U.S. treasury was at 2.15 per cent in December 2015. It’s 2.3 per cent today,” he says. “Outside of those two shocks, rates haven’t moved that much.”
Still, with all of the talk about rising rates, what kinds of strategies can pension plans use for their fixed-income portfolios to ensure decent returns?
A variety of options
“I think we’re seeing, across the spectrum, a pickup in liquid and illiquid credit,” says Marcus Turner, director and senior investment consultant at Willis Towers Watson. “Liquid credit is probably where we’re seeing the first bit of interest; it’s easier to access.”
But more institutional investors are starting to look closely at illiquid credit, according to Turner. While they give up liquidity, “most institutional investors can afford to be sellers of liquidity,” he says. “They’re starting to play around with direct lending or other sources of illiquid credit, and I think it’s just the attractiveness of the returns.”
But what’s the catch? “There are a number of different areas that bond managers can look for higher yield,” says Blaine Pho, chief investment officer for fixed income at Greystone Managed Investments Inc. “But they certainly come with higher risk, and some are riskier than others.”
He points to mezzanine debt, which typically involves a short duration and better yields but at a higher risk. There’s also traditional high-yield debt issued by companies with lower credit ratings. “Those yields can range anywhere right now from five per cent to six per cent, all the way up to in the teens when we’re in a recession and equities are selling off quite aggressively,” says Pho.
According to Turner, when pension plans have traditionally wanted to diversify their bond portfolios, The fundamentals of what drives interest rates — inflation and growth — still don’t look all that they’d look to liquid credit, high-yield bonds and bank loans, typically in developed markets. Now, however, pension plans are starting to experiment more with alternative forms of credit, such as emerging market debt. “That comes with higher risk, because they’re taking on corporate debt and lower-rated government debt, so they’re getting currency risk and lower-rated government risk,” says Turner.
Securitized credit, such as mortgage-backed securities, is also a popular option. “[Securitized debt] looks like a bond and smells like a bond but it’s not a bond underlying the cash flows,” says Turner. “It’s a group of leases that have been pooled together.” Again, the returns can be higher, he notes.
Another option is private debt. A 2015 report from Intermediate Capital Group found 54 per cent of institutional investors had invested in private debt at the time, with another 13 per cent thinking about doing so. “[In private debt], duration is low, so interest rate sensitivity is low if rates do rise and capital depreciation isn’t as severe,” says Pho. “You have a higher running yield, and that’s really attractive, and you have well above inflation on those securities.
“We are talking to our clients about private debt, offering it through Canadian commercial mortgages that we underwrite, but our clients need to be aware that the more you get into private debt, the higher the correlation it’s going to be to equities when equities do sell off.”
Recent examples of some of the strategies in action include a 240-million-pound ($400-million) corporate mezzanine development facility provided by the Canada Pension Plan Investment Board late last year to a British property investment and development company for a mixed-use project at Wembley Park in London, England. The pension fund’s private real estate debt program represents 10.7 per cent of its overall real estate portfolio, totalling $4.8 billion at the end of its 2017 fiscal year and increasing by 18.2 per cent over 2016.
The research burden
The challenge when it comes to implementing some of the strategies, however, is research. That’s the trade-off, according to Andrew Torres, founding partner and chief executive officer at Lawrence Park Asset Management. “Some of these [strategies] take more fundamental research; they take active portfolio management. Some of the institutional clients clearly don’t have the infrastructure to look at that,” he says, adding that in that case, looking externally can be appropriate.
For example, private debt or an active credit strategy “takes more active management to get it right because taking a broad-brush approach won’t necessarily generate the returns,” says Torres. “So much of the fixed-income market is about access to information and access to liquidity, much more so than you get in the equity markets.”
Look before leaping
While the current outlook for interest rates does raise questions about returns from fixed income, Manuel Monteiro, a partner in the financial strategy group at Mercer, notes there are upsides. While returns may suffer, the positive impact on pension liabilities generally outweighs the downsides, he says.
That was the case when bond yields started to rise in late 2016, according to Monteiro. “Even though the bond returns were terrible, the funded position improved significantly,” he says. So rather than making tactical calls about when interest rates may rise, Monteiro suggests plans should keep the focus on using their fixed-income portfolios to match their liabilities. “I think it’s a mug’s game to try to bet on where interest rates are going to go,” he says, noting the years of speculation that an increase was imminent since interest rates had been so low for so long.
Similarly, other industry experts stress the need for pension plans to stop and consider why fixed income is in their portfolios in the first place before they turn to the various strategies in search of higher yields. “You need to understand what your fixed-income portfolio is used for. That drives the extent to which you may or may not be concerned about interest rate exposure,” says Turner. “After you’ve made that decision, if your fixed-income portfolio is clearly there to improve your return-risk profile of your overall portfolio, you then need to assess whether traditional credit is diversified enough in this current environment.”
O’Gorman agrees. “Despite yields being low, and even if plans are worried about rising rates, there’s a role fixed income plays in diversification, in offering low or negative correlations versus some of those other asset classes,” he says.
Larger pension plans, according to Torres, are taking the environment of low interest rates in stride. “They have a fairly diversified approach to fixed income, so even though the fourth quarter [of 2016] was challenging, they took a longer-term approach and they’re diversified,” he says, adding that as plans typically match liabilities, they may not focus as much on quarterly results.
Still, some executives of larger plans, like OPSEU Pension Trust president and chief executive officer Hugh O’Reilly, admit there’s more than just the bond market to worry about. “Assets are all very expensive, and when assets are expensive, that means future returns are harder to get,” he says. “And with recent developments politically, there’s uncertainty around the future direction of monetary and fiscal policy, [which] can have a big effect on investment returns.”
According to O’Reilly, bonds play a number of roles at OPTrust: they generate returns, hedge liabilities and diversify. “Despite the fact that interest rates are low, bonds are still really important to us,” he says.
While larger pension funds may not worry too much about the current environment, that’s not the case for all plans. Smaller defined contribution pension plans and foundations and endowments, says Torres, may find the current environment a concern. “The fourth quarter was a challenging one for fixed-income funds; it left a lot of people disappointed with their returns on the year. But the question is, is this the start of a multi-year normalization of interest rates that’s going to depress or create negative returns for fixed income for a while yet? Those are the conversations we’re having,” says Torres.
“I think managers and sponsors are just trying to get their heads around what the options are. Do they have to lower their weighting in fixed income or are there other solutions that can maintain returns even when rates are rising?”
Torres acknowledges that fixed income has been a bit of an afterthought for investors. “There has been a bit of a set-it-and-forget-it mentality for a number of years,” he says. “If we move into perhaps a new era of either low and stable interest rates or low and rising interest rates, the old equation around fixed income will change. But there are definitely still ways to make money in fixed income and generate very respectable returns.”
Brooke Smith is a Toronto-based freelance writer and editor.
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