It looked as if the long wait for higher interest rates was finally over back in May. That’s when U.S. Federal Reserve Chief, Ben Bernanke, made comments heard by bond investors around the world: he hinted the Fed had imminent plans to slow down or “taper” its historic bond buying program.
But as suddenly as it began, talk of tapering stopped. U.S. employment data hasn’t been as robust as policymakers had hoped. And other issues are brewing: geopolitical risk in countries like Syria, structural and economic problems in China and Japan and an emerging market growth rate that is hitting some bumps on the road. When the Fed surprised markets in September by announcing the stimulus program would continue, one thing became clear: low interest rates are here to stay, at least for the foreseeable future.
This has created a great deal of uncertainty for fixed income investors, especially DB plan sponsors for whom rising rates would signal significant and much-needed relief on the liability side of the pension equation. Low interest rates have been a big challenge, especially as many struggle to claw back from underfunded positions.
In the face of continued concern about the health of the global economy, plan sponsors will need to position themselves for the possibility that interest rates could remain low for a long time. That means rethinking the core fixed income portfolio and introducing other kinds of bonds—or plus sectors—that provide enough of a return to meet liabilities over the longer term.
Expanding horizons
The good news is the fixed income spectrum now offers a myriad of new asset classes for yield-hungry plan sponsors to choose from. Many pension investors have spent the last few years expanding their horizons, venturing outside of Canadian government bonds and into the growing areas of global bonds, corporate bonds, high yield bonds, floating rate debt and emerging market debt. These so-called plus sectors have proven to be an excellent way for plan sponsors to give their core bond portfolios a much-needed boost of alpha.
Yields on some of these assets are impressive especially compared to low yielding Canadian government bonds. U.S. high yield bonds for example have yielded in the range of 6.72% to 21.71% between 2003 and 2012. Compare that to 2.23% to 5.01% for Canadian government bonds and you get a good idea of why more Canadian plans are taking a serious look at plus sectors.
The case for a multi-sector approach
But while each of these asset classes offers an opportunity for improved returns, they also have markedly different risk profiles. For plan sponsors whose fixed income investment is based on capital protection and modest yield production, the challenge is finding a way to use plus sectors to produce better portfolio returns, without adding too much risk and volatility.
Using plus sectors requires diversification and a clear focus on the intricate dynamics of bond markets. Because different types of fixed income respond differently to changes in inflation, interest rates and economic conditions, their returns are not perfectly correlated. At the same time, plan sponsors must also understand that correlations between some types of bonds can change rapidly, altering the type of diversification they offer.
It’s important to understand how all these pieces fit together in a pension portfolio—not an easy task given the myriad of variables that drive returns from sector to sector and from asset class to asset class.
A tactical multi-sector approach allows plan sponsors to broaden their fixed income portfolio and capture alpha from plus sectors in a way that’s designed to respond to changing market conditions and dynamics. That kind of tactical approach is key to ensuring that new fixed income asset classes don’t introduce added volatility and risk-taking within the portfolio.
No one knows for sure where interest rates are headed, but it’s likely they will stay low for a little while longer and plan sponsors should be prepared. Plus sectors are fast becoming a staple within the bond portfolios of many pension plans in Canada. But as international risk continues to rise and the global economy continues to struggle, a tactical multi-sector approach is essential for adding the right kind of diversification and creating a portfolio that will truly benefit from the changing dynamics of the global economy without a lot of extra volatility.