INVESTMENTS
Yieldof Dreams
Bond market challenges are sending pension plans
large and small in search of alternative strategies
By
Colin Ripsman
GETTY IMAGES
P
ension plans have historically
relied heavily on fixed income
investments. The regular
interest payments on bond
investments are good matches for the
regular pension payments made to
pensioners. At the same time, bonds offer
safety of principal and lower volatility
than stocks. Today, it’s common for
many smaller plans, with assets under
$100 million, to hold between 40% and
45% of the portfolio in a traditional or
“universe” bond portfolio. More mature
plans, with a high proportion of longservice members and retirees, may hold
an even larger allocation to bonds.
Over the past three decades, the bond
allocations of these plans have had a
spectacular run of strong returns.
Between 1980 and 2012, bond yields fell
steadily from a high of 19.1% in 1981 to
2.3% in 2013 (see chart, right). As bond
yields fell, bond investments benefited
from capital gains from their investments,
and bond prices rose steadily as a result of
falling interest rates.
Over this period, pension plans
witnessed several serious stock market
corrections, including Black Monday
(1987), the tech wreck (2000) and the
credit crisis (2008) (see chart, page 46).
As a result, the annualized return of the
DEX Universe Bond Index, which tracks
the Canadian bond market, actually
outpaced that of the TSX (9.7%,
compared with 8.4% as of Dec. 31, 2012).
Today, the DEX Universe Bond Index
has an average yield of about 2.3% and a
duration of approximately seven years. A
seven-year duration means that if the
yield curve (i.e., bond yields across the
full-term spectrum) were to immediately
shift up by 1%, the DEX would fall by
approximately 7% (i.e., a return of -7%).
But as pension plans begin to look for
alternatives in the face of the current
investment environment—characterized
by low and rising bond yields—factors
that prevent smaller plans from getting
exposure to certain asset classes could
throw these plans a curve ball. Fortunately,
there are ways for smaller plans to work
DEX UNIVERSE BOND INDEX YIELD
Source: eVestment
BenefitsCanada • October 2013 / 45
TSX TOTAL RETURN INDEX (TRI)
Source: eVestment
around these limitations and find fixed
income yield.
In the first half of 2013, bond yields
began to rise again. The yield of the DEX
Universe Bond Index has risen by almost
0.5%, resulting in a negative return
(-1.7%). Many economists expect bond
yields to continue to rise, as central banks
in North America begin to unwind
expansionary monetary policy involving
open market bond purchases designed to
keep bond yields artificially low. Both
U.S. and Canadian central banks have
been signalling the slowing and eventual
end of practices such as the U.S.
quantitative easing programs, which have
helped to maintain artificially low
interest rates.
A low and rising bond yield
environment will introduce new
challenges for a generation of pension
investors, many of whom have never
experienced this type of bond
environment. Pension plans can expect
low or negative returns from their bond
portfolios over the next three to five years.
So what’s a pension plan sponsor to
do? Larger pension funds can use the
following techniques to try to limit
investment losses in their bond portfolios
in a rising interest rate environment.
Duration Solutions
These fixed income investments act to
shorten the duration of the bond
portfolio. (Shorter duration bonds are less
sensitive to rising interest rates, meaning
that they will have lower capital losses
when interest rates rise.)
• Canadian corporate bonds – A corporate
bond fund comprises corporate bonds
only. This fund will generally have a
46 / October 2013 • BenefitsCanada
shorter duration than the DEX Universe
Bond Index and will also provide a
higher yield to compensate investors for a
slightly higher risk of default, relative to
government bonds. While the DEX
currently includes a 28% corporate bond
allocation, a separate corporate bond
allocation will enable a plan to
overweight its corporate bond allocation.
• Mortgages – A mortgage fund
comprises diversified commercial
mortgages. Since most Canadian
mortgages have a term of five years or
less, a mortgage fund will have a much
shorter duration than the DEX. Since
mortgages are not as liquid as bonds, they
tend to compensate investors with a
higher yield than traditional bonds.
Yield-enhancement Strategies
These strategies involve investing in
bonds with higher interest payments.
• High-yield bonds – A high-yield bond
fund invests in corporate bonds that are
rated below investment grade (BBB).
These bonds are not included in the
DEX, which is restricted to investmentgrade issues. In exchange for assuming a
higher risk of default, investors are
compensated with a significantly higher
interest rate. Despite the higher default
risk, the default rate among U.S. highyield bonds in 2009—the depths of the
credit crisis—was only 10% and dropped
back below 2% in 2010 and 2011.
Another benefit to high-yield bonds in
a rising interest rate environment is that
they tend to have a very short duration. A
high-yield bond fund could focus on
Canadian, U.S. or globally diversified
high-yield bonds.
• Global bonds – A global bond fund
comprises non-Canadian government
and corporate bonds. A global bond
mandate will allow an investment
manager to find bonds in countries that
better compensate investors for assuming
investment risk. For example, in 2008
and 2009, when a flight to quality
reduced Canadian and U.S. federal bond
yields to extremely low levels, global
bond managers were able to find
countries with higher yields to generously
compensate them for the risks they were
assuming. Likewise, a global bond
manager can compare companies in
similar industries around the world and
identify mispriced bonds that are
overcompensating investors for the risks
assumed. Global bond funds have
historically offered a higher yield than
comparable Canadian universe bond
mandates.
• Emerging market debt (EMD) – EMD
funds comprise government and
corporate debt in emerging markets.
Despite the improving financial positions
of many emerging market economies—
which have lower government debt levels
than many developed countries and
improving credit ratings—the risk
premium demanded from investors is
quite a bit higher than that demanded
from investors in developed economies.
An EMD mandate will allow an
investment manager to find bonds in
emerging market countries that provide
access to faster-growing economies and
improved government finances
(compared to many western economies).
EMD portfolios have historically offered
a higher yield than comparable Canadian
universe bond mandates. However, a
significant percentage of the bonds will
be rated below investment grade.
Fixed Income Alternatives
These strategies involve investing in other
asset classes that deliver regular income,
such as bonds, with less sensitivity to
interest rate movements.
• Real estate – A typical real estate fund
will allow a pension fund to invest in a
diversified portfolio of income-producing
commercial and industrial real estate. As
with bonds, real estate portfolios provide
yield (through rental income), which will
make up a large percentage of the total
return. Real estate returns will also
compensate investors through capital
gains, which have more equity-like
characteristics, so a significant portion of
their return comes from capital gains,
rather than from regular interest
payments from bonds. At the same time,
real estate investments are priced to
compensate members for the reduced
liquidity of individual properties.
• Infrastructure – A typical infrastructure
fund will enable a pension fund to invest
in a diversified portfolio of incomeproducing infrastructure projects.
Infrastructure funds offer opportunities
to invest in public infrastructure such as
transportation networks, health and
education facilities, communications
networks, and water and energy
distribution systems. These essential
services projects require long-term
investors, as liquidity may be restricted
and the investments may require initial
development periods in which the return
is limited. However, over the long term,
these investments produce higher yields
than even real estate portfolios, with low
volatility levels. Infrastructure
investments are particularly attractive
to pension investors because of their
long-term, stable cash flows, which are
often indexed to inflation levels.
The challenge for small to mid-size funds
is getting access to these alternative
investment strategies. Some of the key
issues that smaller plans face include the
following:
• Higher cost structures – Most
investment products offer a tiered fee
schedule that reduces fees as the asset
size grows. This results in a lower
net-of-fee performance for smaller plans
relative to their larger counterparts.
• Smaller investment opportunity set –
Minimum asset size limits have
prevented smaller plans from accessing
certain asset classes, such as real estate
and infrastructure, whose risk and return
characteristics can enhance portfolio
performance.
• Limited resources – Limited budgets for
monitoring and oversight often force
smaller plans to use easier-to-manage
investment structures, limiting the
number of managers and asset classes
employed.
Many large plans will limit alternative
investment allocations to 10% to 15% of
the portfolio. For a smaller pension fund
with assets of about $50 million, this
would represent an alternatives budget of
roughly $5 million to $7.5 million. This
limited budget might preclude the use of
many alternative asset classes or entirely
eliminate the opportunity to diversify
across multiple strategies, since many of
these individual strategies require a
minimum commitment of $5 million to
$10 million. Canadian real estate may be
the exception, where some managers will
accept amounts below $5 million. But
despite the challenges of scale, there are
ways for smaller plans to use some of these
strategies to better protect their portfolios
in the face of low and rising bond yields.
Consider the following approaches.
• Shortening portfolio duration – Most
traditional bond managers can adjust the
duration of a traditional fixed income
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portfolio by increasing the allocation to a
short-term bond or money market fund.
Some managers may offer a pooled
corporate bond fund, which enables a
smaller pension fund to increase the
corporate bond weighting in its fixed
income allocation. These options will
allow a pooled fund investor to shorten
the bond duration and marginally increase
the portfolio yield above that of a regular
pooled universe bond mandate.
• Exchange-traded funds (ETFs) –
ETFs represent a basket of securities
that tracks an index. These funds are an
inexpensive way for smaller plans to get
exposure to asset classes such as real
estate and infrastructure. Real estate
ETFs can provide exposure to a range of
real estate investment trusts representing
large segments of the real estate market.
Infrastructure ETFs provide exposure to
a broad range of companies, with a
significant exposure to infrastructure
projects.
The primary disadvantage to ETFs is
that they do not always closely track the
price movements in the underlying asset
because their price movements may be
influenced by sentiment toward the
underlying management teams of the
constituent corporations. They are listed
like stocks and continuously valued, so
they will experience higher volatility than
the underlying asset—and, in certain
cases, the ETF may incorporate high
levels of leverage.
are increasing their ability to leverage a
broader set of alternative fixed income
products for smaller pension funds. In
some cases, these opportunities are a
result of increasing knowledge and
exposure to key managers in this space.
In other cases, they result from using
shared alternative structures across a
larger client base.
• Core-plus bond strategies – These
strategies are similar to core bond
strategies in that their investments are
mainly within the DEX Universe Bond
Index. However, they allow the bond
manager to opportunistically invest a
portion of the portfolio (usually about
20% to 25%) in a diversified range of
alternative bond strategies that could
include high-yield bonds, mortgages,
foreign bonds and EMD. Core-plus bond
strategies enable smaller plans to access a
broad range of yield-enhancement and
duration strategies within one fund.
Pension plans that continue to rely on
fixed income investments will need to
more actively manage these allocations in
order to maximize fixed income returns
going forward. For smaller plans, this
represents a large challenge, due to their
limited scale and resources. However,
with a little diligence and creativity, they
may be able to replicate many of the same
strategies employed by their larger
counterparts. Using portfolio duration
and yield-enhancement tools to maximize
returns from their fixed income portfolios
will give smaller plans that home field
advantage.
• Leveraging alternatives – As expertise
in and exposure to these newer asset
classes grow, investment consulting firms
Colin Ripsman is a principal with Eckler Ltd.
[email protected]
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October 2013
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