Friday, November 13, 2009

Feds Show Caisse How it's Done?

Peter Hadekel reports in the Montreal Gazette that Feds show Caisse how it's done:

Critics have plenty of reasons to dump on the performance of Quebec's pension investment agency, the Caisse de dépôt et placement.

One more reason came yesterday, when quarterly results were released by the Caisse's counterpart in the rest of Canada, the Canada Pension Plan Investment Board.

The CPPIB enjoyed a modest 4.6 per cent gain in the second quarter. It has earned $13 billion in investment income this year and is taking full advantage of the rebound in the Canadian stock market.

The same can't be said of the Caisse, which is missing the boat on the recovery. Finance Minister Raymond Bachand confirmed this week the Caisse will underperform other big pension funds in 2009 because it had a smaller weighting in stocks at the start of the year.

Of course, that's not the only difference to note between the CPPIB and the Caisse.

An obvious one is the very fact the CPPIB reported its quarterly results at all. The federal agency follows a policy of regular disclosure, while the Caisse sticks stubbornly to the practice of reporting its results just once a year.

The predictable result is an almost constant climate of rumour and conjecture surrounding the Caisse.

This week, La Presse quoted unnamed sources as saying the Quebec fund is on track for just a five or six per cent return this year - about half what other large Canadian pension funds will earn.

True or not? The Caisse won't say.

But while the feds leave the CPPIB to fend for itself, Quebec cabinet ministers regularly must rush to the Caisse's defence.

Another big difference is that the CPPIB avoided the disastrous market for asset-backed commercial paper, while the Caisse got heavily entangled in it and suffered several billion dollars in losses when the financial crisis hit.

That mess caused a liquidity squeeze, forcing the Caisse to sell stocks and reduce its equity exposure. The Quebec fund also racked up losses on its trading in the Canadian dollar, which again forced it to lower stock holdings and left it on the short end on the market rally that began this year.

The biggest discrepancy is the one that matters most: performance.

The Canada Pension Plan is adequately funded to meet future obligations if it can earn an annual return of 4.2 per cent. If it does that, it won't need to raise contribution rates to provide retirees with the pension benefits they've been promised.

The Quebec Pension Plan, by contrast, looks like a ticking time bomb. It will need double-digit annual returns to make up lost ground.

Even before the Caisse reported a 26-per-cent overall loss for 2008 for all its depositors, the Quebec Pension Plan was facing trouble because of unfavourable demographic trends. Add a $9-billion loss in assets in the QPP because of last year's meltdown at the Caisse, and the mountain to climb looks even steeper.

There are several reasons why the Canada Pension Plan is in better shape: Population growth in the rest of Canada is higher; average income is higher; average age is younger; people are retiring later, on average.

In an analysis published this year, the C.D. Howe Research Institute stated the Quebec government will have to take immediate steps to deal with the problem.

The choices are not pleasant. If pension benefits are to remain the same, Quebec will have to hike the contribution rate from the current 9.9 per cent of pensionable earnings to 11.1 per cent (split equally between employers and workers).

That change, a C.D. Howe analyst calculated, could amount to an extra burden of $1.25 billion a year on the province's economy.

The other option is to cut benefits or limit their indexation to inflation. But the political price on that might be too high.

In the meantime, one thing Quebec can fix is the risk-taking, cowboy culture at the Caisse. That process is already under way under new boss Michael Sabia.

Give him some more time. This year's results, if they do fall below average, won't be his fault, as he inherited a bad asset mix at the start.

Mr. Sabia inherited a big mess but he has cleaned house and put together his team. And to be sure, the Caisse will underperform its peers that are more weighted to public equities.

But let's step back a second and understand a few things. Unlike the CPP which is a partially funded plan, the Caisse manages the assets of mature, fully funded pension plans so it needs to emphasize risk management in order to closely match its assets to their liabilities. After a disastrous year like 2008, the mismatch between assets and liabilities really got exacerbated, so they need to regroup and rethink their strategy going forward.

On Friday, Bloomberg reported that the Caisse may sell C$8 billion in bonds by 2010:

Caisse de Depot et Placement du Quebec, Canada’s biggest pension-fund manager, plans to sell as much as C$8 billion ($7.6 billion) of bonds in Canada, the U.S. and Europe by the end of 2010.

The bond sales would replace part of Caisse’s short-term borrowing program with longer-term debt and won’t increase leverage, Montreal-based Caisse said today in a statement. Foreign-currency-issued debt will reduce the need to hedge against swings in the Canadian dollar, it said.

“They’ve had a short-term borrowing program and they may want to extend it out to fix it, which is understandable given the low interest-rate environment,” said Benoit Lalonde, vice president of fixed income at Laurentian Bank of Canada in Montreal. “I would imagine there’s an issue coming soon.”

The Caisse, which oversaw C$120.1 billion after reporting a record loss of C$39.8 billion for 2008, is set to post a return on investments of about 5 percent to 6 percent this year, compared with an average gain of 10 percent to 12 percent for Canadian pension funds, La Presse newspaper reported on Nov. 11, citing unidentified people familiar with the matter.

The Bank of Canada held its benchmark interest rate at a record low 0.25 percent at its Oct. 20 meeting and pledged to keep it there through June 2010, barring changes in the outlook for inflation.

Commercial Paper

CDP Financial Inc., the Caisse’s financing arm, will carry out the sales in series with terms up to 30 years, DBRS Ltd., a Toronto-based rating company, said in a statement. Proceeds will be used to “significantly reduce” the amount of commercial paper outstanding, DBRS said. It expects the debt to be AAA, its highest rating, pending a review of final documents.

“Investors will consider that paper similar to senior bank debt,” Lalonde said. “The Caisse de depot is not an institution that’s in any danger of folding.”

Caisse will “meet with several investors in the weeks to come,” spokesman Maxime Chagnon said in an interview. He wouldn’t comment on timing of the debt sales.

“Because of today’s historically low interest rates it’s a good time to lock in” long-term financing, he said.

The refinancing will provide “better asset-liability term matching” for the Caisse’s U.S. real-estate portfolio and other assets, DBRS said.

Bertrand Marotte of the Globe and Mail added this in his article on the Caisse's refinancing program:

The new long-term debt will be used to replace some of the institution's short-term debt, a move the Caisse says will increase the stability of financing sources.

“By limiting our exposure to the uncertainties inherent in short-term funding and by better matching the duration of our sources and uses of financing, the refinancing program is another important element of our plan to reduce financial risks and to strengthen the foundations of the Caisse,” the fund's president and chief executive officer Michael Sabia said in a news release.

“In addition, this initiative will contribute to our effort to improve returns over the medium term by locking in financing at today's historically low interest rates” he said.

The Caisse has been hit hard by the global financial meltdown and under the recently appointed Mr. Sabia it has been moving to boost its risk-management safeguards and reduce its exposure to high-risk areas.

Quebec Finance Minister Raymond Bachand said on Wednesday that the Caisse missed out on the initial stock-market rally earlier this year and will likely underperform its peers in 2009.

The Caisse last year reported a huge $40-billion loss on its investments, equal to a negative return of 25 per cent, compared with an average return for its Canadian pension fund rivals of minus-18 per cent.

In a financial update in August, the Caisse said it had to take $5.7-billion in writedowns related to risky commercial real estate loans and private equity bets.

Credit-rating agency DBRS said Friday that the new $8-billion refinancing program “will provide better asset-liability term matching for investments such as the U.S. real estate portfolio.”

DBRS said it expects to rate the new notes to be issued by the Caisse as AAA, barring any intervening events.

The rating agency said it maintains its overall AAA credit profile of the organization.

Basically the refinancing program provides better asset-liability term matching, it reduces leverage and acts as a natural hedge for foreign currency exposure. This is a smart move.

As for disclosure, I already mentioned that CPPIB only discloses the performance of public markets on a quarterly basis, not that of private markets. Moreover, unlike the Caisse, CPPIB does not clearly disclose the benchmarks governing their private markets (real estate, private equity and infrastructure). There are just some vague and complicated references to them in their annual report, but no clear disclosure.

As mentioned in the article above, the Caisse already announced hefty writedowns in commercial real estate loans and private equity bets. I am curious to see what writedowns, if any, CPPIB will report in private markets at the end of their fiscal year (March 31st).

Finally, let me emphasize that what counts is risk-adjusted returns and alpha. For example, a wiser (risk-adjusted) asset mix move on the part of pension funds would have been to have gone overweight AAA corporate bonds at the start of 2009 and lock in big returns as spreads came in from historic highs. Many big funds did exactly that.

But the big moves in stocks and corporate bonds have already taken place. With a tsunami of liquidity chasing yields across the globe, spreads have tightened back to pre-crisis levels.

Heading into 2010, pension funds will have to focus on relative value - ie. true alpha generation - to add value to the policy portfolio (beta portfolio). And if that is the case, there is no doubt in my mind that the Caisse will show its peers "how it's done".

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