Monday, September 11, 2017

Canada’s Pension Funds Lever Up?

Julie Segal of Institutional Investor reports, Canada’s Pension Funds Lever Up:
Canadian pension plans are among the most admired institutional investors for their prowess as money managers. Now pension plans in Canada are upping the ante, increasingly issuing long-term bonds and using the borrowed money, or leverage, to try and generate even better returns, a new report shows.

Much of the money raised will back private equity investments, a big source of outperformance for the top-ten Canadian pension plans, according to a research report on pension plan debt issuance that will be released this week by capital markets technology firm Overbond. The company is an electronic platform for primary bond issuance, directly connecting issuers with investors.

“On the back of their huge private equity businesses, Canadian pension plans have become debt issuers themselves,” says Vuk Magdelinic, CEO of Overbond.

According to the report, Canadian pension plans are taking advantage of their strong long-term track records and high credit ratings to issue debt at low rates. The report is based on interviews with institutional investors and data from the Overbond platform. The platform allows issuers to identify potential bond buyers, as well as benchmark and price issues.

“The plans want to lever up, but not at all costs,” says Magdelinic. One such recent deal: AIMCo Realty Investors, a division of Alberta Investment Management Co., issued C$400 million ($327 million) in seven-year senior unsecured notes on June 26th.

Plans are using borrowed money to try and counter the pressure from the falling number of active workers that are supporting their retirees. Institutional investors, particularly corporate pensions, have been eager to buy bonds issued by the Canadians.

“The market is hungry for new bonds, and this is a quality type of issuer,” says Magdelinic. “Financing private equity through the bond market is an efficient form of financing.”

Issuing bonds is not the only way institutional investors can leverage their portfolios. They can also directly invest in hedge funds and other vehicles that use complex derivatives.

All but one of the top-ten Canadian pension plans have more than 20 percent of their portfolios in private equity, an allocation that has contributed to excess returns over the past ten years, according to the Overbond report. Ontario Teachers’ Pension Plan, for one, has a whopping 46 percent of its portfolio in private equity.

“In order to fund more PE acquisitions and maintain high returns, pension plans are more inclined to issue long-term debt securities,” write the report’s authors. Eight of the top-ten Canadian pension plans have issued debt, with $32 billion currently outstanding, or 2 percent of their combined assets.

Five-year annualized returns for the top-ten Canadian funds hover around 10 percent, compared with the 2 percent generated by the S&P TSX Total Returns index. Still, many Canadian pension funds need more. They have to support a growing number of retiring baby boomers through longer life spans than previous generations.

At the same time, fewer workers, who pay into the pension system with each paycheck, are joining the public sector than are retiring, putting more pressure on other income sources. According to the report, OMERS, the Ontario pension for municipal workers, had nine active employees for every retiree in 1976, four in 1986, and less than two active workers per retiree in 2016.

Canadian public pensions are issuing debt to increase returns, even as corporate pensions are selling bonds to fill funding holes. In July, Kroger, the U.S. supermarket chain, issued debt to help the underfunding of its pension plan, while FedEx did the same in January.
It's been a couple of years since I discussed Canada's highly leveraged pensions so I'm glad Julie Segal reported on this as there are a lot of myths attached to how Canada's large public pensions use leverage to intelligently juice their returns.

First, a note on the article. It states Ontario Teachers’ Pension Plan has a whopping 46 percent of its portfolio in private equity. This is false. Ontario Teachers' just published its 2017 mid-year results which shows you an exact breakdown of its asset mix (click on image):


As you can see, as of June 30, 2017, 16 percent of its total portfolio was in non-publicly traded equities (ie. private equity), not 46 percent.

I think what Julie meant was 46 percent of Ontario Teachers' portfolio is in private markets because if you add up Private Equity (16%), Real Estate (14%), Infrastructure (11%), and Natural Resources (3%), you get 44% which is close to her 46% but still doesn't add up to her figure.

Nonetheless, this little arithmetic error aside, the article is correct, Canadian pensions are increasingly issuing debt to fund investments in private markets.

Back in June, Barry Critchley of the National Post reported, AIMCo joins list of pension funds issuing debt:
For the second time in a week, Canadian pension funds have demonstrated that their debt offerings are more than welcome anywhere — even in markets where they haven’t been before.

Wednesday, AIMCo Realty Investors LP, a unit of AIMCo, an Alberta Crown corporation with almost $100 billion in assets, launched its initial debt offering in Canada. The unit hoped to raise $400 million by way of an offering of seven-year senior unsecured notes.

Before noon, the $400-million target was reached — and word is that because of strong demand, the issuer could have raised more — and AIMCo was required to pay 2.266 per cent. The notes, which could only be sold in Canada, were rated AA low by DBRS.

In an email, AIMCo said the “debt issuance is a highly cost-effective financing strategy that will provide a new source of funds and liquidity, as well as, enhance returns for AIMCo’s clients.”

It plans to use the proceeds to repay a revolving credit facility and for general corporate proceeds.

One week back, it was CPP Investment Board’s turn to branch into new markets. CPPIB Capital, a unit of CPPIB, launched its initial offering of euros and raised 2 billion euros over a seven-year term at a coupon of 0.375 per cent. Given that the senior unsecured notes — rated AAA by four rating agencies — were priced at a slight discount, the yield to maturity, at issue, was 0.465 per cent.

And as further proof that things go in threes, last Friday, Montreal-based PSP Capital Inc. priced a $1.75-billion five-year offering of senior unsecured notes. For that privilege, the borrower was required to pay 1.73 per cent. TD, BMO and CIBC were joint leads on the private placement.

These three recent offerings, two of which were in new markets, continue a trend that started in late 2001 when Ontrea Inc. a real estate, non-taxable company owned by Ontario Teachers Pension Plan Board, became the first pension fund to issue debt. It raised $600 million of AAA-rated debt at 5.7 per cent with the interest payments and repayment of capital unconditionally and irrevocably guaranteed by the fund. Such a guarantee was possible because of provincial legislation.

One year later, OMERS, through OMERS Realty, entered the debt issuing game with its initial offering. In 2003, CDP Financial Inc., the funding arm for subsidiaries of the Caisse de depot, raised $750 million for five years in what was its inaugural issue. Those offerings were rated AAA.

All those entities have continued to borrow — some in different form. Last March, Cadillac Fairview Properties Trust, a unit of Ontario Teachers, raised US$1 billion in its initial offering. The AAA-rated issuer was established to hold all of the shares and inter-corporate debt of Cadillac Fairview Corp. and Ontrea (In effect, the ownership, valued at $22.4 billion, was transferred to the trust from Teachers.)

bcIMC Realty Corp. OPB Finance Trust, and PSP Capital have also issued debt, not all of which was rated AAA. But of all the pension funds, the CPPIB has been the most active borrower.

According to its latest annual report, for the 12 months ended March 31, it raises external debt under a global medium term note program. It does that by selling unsecured senior notes by way of private placements. In all, when its Canadian borrowings are included, it has $8.8 billion of debt outstanding. It also has issued $11.1 billion of commercial paper via its Canadian and US programs.
Canada's large pensions are using their AAA balance sheets to ramp up their commercial paper operations.

Last week, after I covered Ontario Teachers' mid-year 2017 results, its president and CEO, Ron Mock, shared this with me in regards to whether these mid-year updates are here to stay:
 "Yes they are here to stay. We now have a commercial paper program. Market needs more frequent updates as other plans do. So it is something we will be doing as an ongoing semi annual process. Mid year and year end."
So, Canada's large pensions are increasingly tapping intro credit markets, issuing bonds to institutional investors looking for yield and loving their AAA credit rating.

Interestingly, a lot of the buyers of this debt are private and public pensions who are well aware the credit risk of Canada's large pensions remains low and they run a tight ship.

So why are Canada's large pensions increasingly issuing debt? As the article above states, some are feeling the demographic pressure of a declining ratio of active employees to retirees.

But that certainly isn't the only reason. CPPIB and PSP Investments don't suffer the demographic pressures of an Ontario Teachers' or OMERS as they aren't pension plans managing assets and liabilities closely. They are pension funds making efficient use of their capital by borrowing cheaply to invest in private markets and make better returns than if they didn't borrow.

The way I explain this to a layperson is let's say you were running a business and had excellent credit, you went to the bank, got a loan at 5% and went out to invest in a project that gave you much higher returns. Doesn't it make sense to borrow even if you have the capital to invest and do it yourself? More often than not, it absolutely does.

I'll give you another example, let's say I wanted to use a $100,000 credit line and invest in some of the biotechs on my watch list moving up big on Monday morning (click on image):


What would you say? You'd say I'm nuts and you're absolutely correct, but a lot of retail and institutional investors buy stocks on margin without using their personal credit line and some are a lot more successful than others.

It all comes to knowing when to borrow, where to invest and in the case of these large, well-diversified pensions, efficient use of capital.

In a previous discussion I once had with HOOPP's President and CEO, Jim Keohane, he explained to me why HOOPP is investing in commercial warehouses in the UK where Amazon will be its lead tenant.

When I asked him why doesn't Amazon which has more money than it knows what to do with just build these warehouses itself, Jim bluntly stated: "Because while we like the 7-8% yield on these investments, Amazon can put that money to work elsewhere and get a much higher return on its investment."

Like Ontario Teachers', the Healthcare of Ontario Pension Plan (HOOPP) is no stranger to leverage. For quite some time, it has been using extensive repo operations to intelligently lever up its massive bond portfolio. Ontario Teachers' has been doing the exact same thing.

Jim told me once: "People think we are increasing risk by leveraging up but they don't understand there is more risk in a traditional 60/40 stock bond portfolio."

What other sources of leverage are Canada's large pensions using? Well, go back to an old discussion I had with Ron Mock which I covered here:
I first met Ron back in 2002 when I was working as a portfolio analyst for Mario Therrien at the Caisse covering directional hedge funds and a few fund of funds. That first meeting left a lasting impression on me. In fact, I was so blown away that kept thinking how I wish I worked for him.

I remember taking a lot of notes in that meeting. I was a junior asking an industry veteran a lot of questions. I was fascinated by hedge funds and didn't want to squander the opportunity to learn as much as possible from one of the world's best hedge fund investors.

Ron started the meeting by stating: "Beta is cheap but true alpha is worth paying for." What he meant was you can swap into any index for a few basis points and use the money for overlay alpha strategies (portable alpha strategies). His job back then was to find the very best hedge fund managers who can consistently deliver T-bills + 500 basis points in any market environment. "If we can consistently add 50 basis points of added value to overall results every year, we're doing our job."

He explained to me how he constructed the portfolio to generate the highest possible portfolio Sharpe ratio. Back then, his focus was mainly on market neutral funds and multi-strategy funds but they also invested in all sorts of other strategies that most pension funds were too scared to invest in (strategies that fall between private equity and public markets; that changed after the 2008 crisis). He wanted to find managers that consistently add alpha - not leveraged beta - using strategies that are unique and hard to replicate in-house.
Of course, it hasn't always been smooth sailing for Ontario Teachers' massive hedge fund portfolio and Ron has learned that the hard way along the way.

But using a portable alpha strategy to invest in a diversified group of hedge funds is an intelligent way to lever up a pension portfolio.

And Ontario Teachers' isn't alone doing this. CPPIB which is now Canada's largest hedge fund investor does the exact same thing, swapping into bond and stock indexes to gain exposure to hedge funds it thinks can add significant sources of diversified risk-adjusted returns.

Are there risks to leverage? Absolutely, especially if we get a spike in rates or even a long period debt deflation I'm worried about.

But Canada's large pensions aren't stupid, they carefully weigh these risks and issue debt in accordance to the projects they're investing in private markets and in accordance to their own liquidity risks which they gauge closely.

Can US public pensions issue their own debt to fund investments in private markets? In theory, yes, in practice no because they don't have the governance to hire people to do this and many of them don't have the credit rating to issue debt at an attractive yield.

Rating agencies have been targeting US public pensions and they will be scrutinizing Canada's large pensions very closely but there are big differences in governance and the way the latter operate independently from any government interference.

Should the Bank of Canada be a lot more cognizant of the leverage Canada's large pensions take? Absolutely, it should and in many cases regulators including OSFI are well aware of the leverage being used at Canada's large pensions. I just think the Bank of Canada should take the lead here and produce in-depth quarterly or annual reports on the use of leverage at Canada' large public pensions.

Does the use of leverage give Canada's large public pensions an advantage over their US counterparts? No doubt about it, it does, but the use of intelligent leverage is predicated on solid governance which allows Canadian pensions to attract highly skilled individuals to manage public and private assets internally.

Below, Jim Keohane, President & CEO of HOOPP explains most people have used derivatives – they just don’t know it. He explains what these financial instruments are and how do they work.

I also embedded a SimCorp promotional clip which explains how HOOPP uses SimCorp to master derivatives. Doing what HOOPP does with derivatives is complex and requires operational know-how and a great integrated investment system to track it all.


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