The Death Of Canadian Fixed Income Management As We Know It
By: Harry S. Marmer
The subtitle of this article could be, ʻHow to lose Canadian fixed income portfolio managers as friends.ʼ Do I perhaps need to take a Dale Carnegie course? While we will leave that question unanswered, it is a fact that the shift towards liability driven investing and the elimination of the Foreign Property Rule are permanently changing the face of Canadian fixed income management. Bond management will never be boring again.
Liability Driven Investing
Liability driven investing (LDI) is currently all the rage in the pension industry, but it is also most likely an enduring one. LDI refers to structuring your asset mix to better match liabilities. In its most logical form, it is a restructuring of your fixed income portfolio to increase correlation with your planʼs liabilities.
Two key factors pave the way for LDI:
- Weak pension fund health
- Lacklustre Canadian fixed income results
Weak Pension Fund Health
It is no secret that pension fund health in Canada is soft. The easiest way to understand this issue is to look at the ratio of pension plan assets to liabilities. Exhibit 1, which displays the Mercer Pension Health Index since 1983, is an illustration of this ratio. This index represents the ratio of assets to liabilities for a ʻmodelʼ pension plan – the higher the ratio, the healthier the plan. The Mercer Pension Health Index peaked around September 2000.
Equity markets were entering a global synchronized bear market that bottomed around September 2002. Bond markets, on the other hand, were continuing their bull market with long-term interest rates dropping over the period by more than 225 basis points from 6.65 per cent to 4.49 per cent. This environment created a ʻperfect stormʼ for pension plans with mismatched assets and liabilities.
The typical pension plan asset mix is 60 per cent equities and 40 per cent mid-term bonds. Solvency liabilities, however, are priced from long-term Government of Canada bonds. With both equity markets and fixed income yields falling, pension plan asset values dropped at a time when liabilities were on the rise. Fixed income assets in the typical plan tend to be of shorter term than liabilities, further exacerbating the gap; so even though interest rates were in decline, bond assets failed to rise as quickly as liabilities. This may help answer the question asked by a Mercer Investment consultant “why does my actuary say bad news, when my bond manager says good news?”
Investment consultants Watson Wyatt found similar results when they examined pension funds in other countries. Pension balance sheet health has generally been weak in developed markets where plans have significant equity exposure and have generally not managed their fixed income from a liability-driven perspective.
Canadian Fixed Income Results
The other factor significantly affecting the Canadian fixed income environment has been active bond management ʼs lacklustre performance in Canada over the past decade.
Examining this issue a little closer reveals that the Canadian fixed income market has indeed had two different fixed income management regimes. During the first regime, from 1986 to 1997 inclusive, the average spread between the first quartile and Mercer median and the third quartile and Mercer median was 72 and minus 62 basis points, respectively.
From 1998 to 2005, the average spread between the first quartile and Mercer median and the third quartile and Mercer median was 37 and minus 36 basis points, respectively. These results are, of course, before subtraction of explicit investment management fees and implicit monitoring costs. Clearly, active Canadian fixed income management over the past five years has been a tough sell.
The Playing Field Has Changed
Weak pension fund health, in combination with lacklustre results from active management of Canadian fixed income, has led sophisticated pension fund sponsors to convert from active fixed income investing with a universe duration benchmark to an indexed long duration approach. After all, why bother with active mid-term bond management if the odds of winning net of fees are low and it does not match well with liabilities?
One other factor will dramatically change the landscape of the Canadian fixed income market, the elimination of the Foreign Property Rule. Canadian fixed income markets comprise only about four per cent of world fixed income markets. Now Canadian fixed income managers can play for opportunities anywhere in the world.
Canadian institutional investors can choose from a number of implementation pathways including Canadian Fixed Income and Non-domestic, Core Plus, Global Aggregate, and Portable Alpha in their attempts to take advantage of this new environment.
The case for global fixed income investing is unprecedented from both an alpha enhancement and beta reduction perspective. The smorgasbord of global fixed income opportunities available to investors includes Global Aggregate, Global Credit, Global Sovereign, Emerging Markets, U.S. Low/ Intermediate, and U.S. core. The expected alpha estimate for first quartile performance ranged from 75 bps to 150 bps.
An analysis of Mercerʼs global fixed income database suggests that the alpha potential for global fixed income management is real and there are fundamental reasons for this alpha potential. The global fixed income arena has a deep and broad opportunity space offering diverse choices. These factors, as well, provide global fixed income investors with diversification benefits relative to Canadian asset classes.
Where Are We Going?
The seeds have been planted for the institutional investing world to significantly change in the future. This is especially true for institutional fixed income portfolios. Institutional investors can go down a number of different road maps in this new environment and my forecast is that performance spreads in the Canadian fixed income manager universe will widen again as more managers add foreign bonds to their portfolios. The movement into LDI will lead sophisticated sponsors to utilize portable alpha strategies to harvest the alpha potential in global fixed income.
Other institutional investors will invest directly in global fixed income strategies to obtain that market exposure, either as a means of reducing some of their systematic risk exposure to the Canadian market or as a strategic call on relative valuation. By extension, Canadian fixed income portfolio managers will have to keep pace with where their clients are leading them.
Harry S. Marmer is senior vice-president at Franklin Templeton Institutional.
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