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Canadian Fixed Income

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Canadian Association of University Business Officers …

Canadian Association of University Business Officers
June 2009

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  • The old days for bonds and why a pension plan would own them was “ pretty simple “ I have a 60/40 portfolio and that seems to be the right allocation so I will make bonds a core holding in the portfolio and my Board will be happy because Canada bonds are safe and they keep the overall portfolio less volatile. We can rest easy at night. I don’t really care so much about returns from my bonds because I know my 40 % equity allocation will always skate my total portfolio returns onside. Also, to make owning bonds even easier I will index the bonds because I can even make money lending the bonds as well. As for my liabilities, I don’t really worry about those because my plan is young and, oh yes, double digit equity returns will make my assets look good and who really needs to deal with the liability side of the equation. Oh yes, if I need long bonds there are Real Return bonds which have a long duration and, oh yes, they protect against inflation too. Finally, my liabilities are in Canada, therefore I am happy to own Canada $ bonds because we like them and it is a simple decision even though we really don’t truly understand our liabilities. And, if I decide to outside Canada with an allocation to Yankee bonds then they must be hedged in my portfolio because I don’t need any incremental returns jeopardized by currency so I will fully hedge this position. And by the way, did I tell you I only spend a few minutes a day on bonds?? I have heard some really smart plans out there are “ immunizing “ their portfolios which mean they don’t even have to deal with their bonds at all. Anyway, I just love the stock market because it returns well over 10 % most of the time.
  • Liability models are popping whether it be based on VAR or some other measure The notion of Canada representing only 3 % of the global economy it becomes a fiduciary responsibility to look outside Canada for incremental returns. Do Canadian bond managers have that expertise? Foreign fixed income managers become educators as plans look outside for investment opportunities and strategies.
  • Balance sheets used to be important, when plans were in surplus the CFOs wanted to make their bottom lines look better and they did with the help of their pension plans. Cash flow is everything now. Plans looking for regulatory relief from “ writing checks”. Companies must now build pension plans together with their corporate balance sheets. They must look to the future and better predict their liabilities and construct appropriate portfolios that serve to “ de-risk “ their pension plans. This will likely lead to greater allocations to longer duration fixed income as a first step. We have seen more use of derivatives over the last few years as synthetic beta allows plans to seek “ alpha “ now from overweighting certain fixed income sectors. Core plus mandates have replaced core holdings as managers go outside their benchmarks to add all important alpha. We saw this a few years ago as Canadian FI managers used HY or EM as the “ plus”. Now the opportunity set for alpha is much broader as more plans go global with their bonds.

Transcript

  • 1. Beyond Vanilla Fixed Income “ From Boring Diversifier to Alpha Source” Jamie Colliver Fixed Income Seminar CAUBO June 2009
  • 2. Fixed Income in Canada
    • Early Rationale for Bond Allocations: Vanilla Ice Cream!
    • Core holding to provide stable returns…flight to quality syndrome,
    • Board/Trustee “feel good, sleep at night”
    • Willing to live with lower returns because equities will outperform…always
    • count on double digit equity returns
    • Index holdings then forget about it…actually be paid to index so your
    • bonds could be leveraged
    • Willing to live with the duration mismatch of liabilities…RRB’s have helped
    • Liabilities in Canada…should own $ C bonds…home bias, we understand
    • domestic bonds even if we don’t understand our liabilities
    • No currency exposure on any foreign bond holdings…fully hedged…any bond
    • returns easily wiped out by currency swings
  • 3. Implications for Pension Plans Investment risk was measured as volatility of returns, or relative to benchmarks not relative to liabilities Asset mix typically 60% stocks 40% bonds Not enough alpha. Too much volatility. Interest rates fell almost continuously since the 1980’s which increased PV of liabilities Stock markets outperformed in the 1990’s then did not meet assumed rates of return when the bubble burst while PV of liabilities grew faster Bond portfolios were short term , usually measured against a Universe Bond Index, so as rates rose, value of bond portfolios did not rise as much as PV of liabilities grew
  • 4. Fixed Income in Canada
    • New Bond Reality : Vanilla Chocolate Chip!
    • 40 - 50 % of total portfolio requires focus:
      • Return source
      • Alpha source
    • Must generate better returns, equities will not subsidize
    • Foreign Property Rule removed...a “world” of opportunity
    • Must move beyond domestic fixed income markets
    • LDI - Liability matching and duration will drive asset allocation
    • Alpha/Beta separation…bond beta cheap
  • 5. Fixed Income in Canada
    • New Reality for Bonds
    • More liability studies undertaken by consultants…liability
    • consultants showing up now with new technology
    • Plans/Boards/Trustees need education in the …...“ World of
    • Fixed Income “….especially markets outside Canada
    • More fixed income customization….replicating yield curves to
    • match duration of assets…LDI
    • More “packaged solutions” for the medium and smaller plans
    • Plans in Canada are finally reviewing their fixed income
    • allocations…looking to “ Core Plus “
  • 6. What About Bonds? Universe courtesy of Mercer Investment Consulting. Calculations monthly in $CDN. Past performance is not indicative of future results.
  • 7. What About Bonds? Greater opportunities globally Rates of Return(%) Expanded Global Opportunities Over 96% of Fixed Income Opportunities Range of 7.9% between top and bottom performers Global Fixed Income Universe courtesy of Evestment. Calculations quarterly in $US. Performance before fees for periods ended December 31, 2008
  • 8. The DB Dilemma It’s real. It’s here! Time to “ de risk “? Fixed Income in Canada
  • 9.
    • 2008 Pension Crisis – Numbers tell everything
    • Solvency Deficiencies
      • Funded ratios dropped from 96% to 69 %
    • 88 % of Canadian executives say we have a crisis (1)
    • 10 % of companies consider their pension plans as a “ threat to their survival “ (2)
    • Corporate earnings down significantly
    • DB assets down 18 %
    • DC returns typically lag DB by 2 % with members assuming investment risk
    • Pension plans must assume risk to secure the pension promise
    • (1)2009 Watson Wyatt/Conference Board Survey
    • (2)SEI
    Fixed Income in Canada
  • 10.
    • DB Dilemma in Canada
    • Plans must reduce liability exposure to DB plans – Solution : DB plans are closing or frozen
    • Financial statements of sponsors more exposed to pension risks
    • Mark to market impact immediate to DB plans with poor performance – should be non-correlated to income statements
    • Sponsors must seek conservative approaches with investment policies and asset allocation
    • Higher allocations to fixed income, long bonds in particular
    • LDI > more swaps and derivatives for synthetic beta
    • Removal of FPR has led to “ Core – Plus “ mandates adding value using HY or EM - more volatility
    Fixed Income in Canada
  • 11.
    • To De-Risk or Not?
    • Corporations cutting benefits and increasing contributions forcing them to consider a de-risking approach even if only extending bond duration
    • Liability matching with bonds or other assets
    • Over 80 % of Plans have say they will not exceed 60 %bonds (1)
    • Real Estate or Infrastructure top list for risk minimization and stabilizing returns
    • Other assets include interest rate swaps/overlays, hedge funds, repos, private debt, RRB’s, and dividend yielding equities
    • Likely make changes within a year or two (1)
    • (1) Benefits Canada
    Fixed Income in Canada
  • 12.
    • LDI is coming….
    • Viewing portfolio construction through an “LDI lens” is a valuable process even if asset allocation is ultimately not changed.
    • No “one-size-fits-all” LDI solution exists.
    • Expect more diversity in asset strategy as plan sponsors incorporate unique circumstances, seek further diversification and embrace asset classes/strategies that offer high potential for active management.
    • For corporate plans, expect a gradual migration from intermediate duration to longer duration and increase in fixed income allocations
    • Envision derivative-based solutions to be more widely accepted as a standard tool to hedge liabilities and port alpha
    • Smaller plans and those seeking simplicity will migrate, at least initially, towards pooled funds
    • LDI affects all steps in the fiduciary process: assessing the existing position, strategic planning, implementation, and performance measurement
    The Case for Liability Driven Investing
  • 13.
    • -Stabilization of spreads starting but likely too early to declare a bottom
    • -Performance driven by liquidity not credit
    • -Liquidity improves just as fundamental economic data deteriorates
    • -Phenomenal opportunities exist right now from risk-adjusted returns available from bonds
    Sector Spreads
  • 14.
      • Plans need to add risk to their portfolios as they re-balance and bonds are now viewed as alpha sources
      • LDI emphasizes long term bonds and need for alpha and diversification
      • Globalization of Canadian fixed income portfolios is evolving, but hurdles remain significant for some plans
      • Effective global bond strategies vs. Canadian liabilities and benchmarks require careful risk management
      • Returns from high quality fixed income are now possible given current sector spreads
    Where do we go now? Ice Cream: no calories