Wednesday, February 28, 2018

Canadian Pensions Cranking Up The Leverage?

Kate Allen of the Financail Times reports, Canadian pension fund issues €1bn, 15-year bond:
Some of the world’s largest pension funds have begun to issue bonds, with the Canada Pension Plan Investment Board today raising €1bn in 15-year debt in the latest example of the growing trend.

CPPIB’s deal — priced at a 1.5 per cent fixed annual coupon — is its second euro-denominated debt-raising, after a €2bn deal last June. The order book topped €4.6bn.

Globally pension funds have issued $28bn of syndicated bonds since 2014 according to figures from data provider Dealogic. The largest proportion of that total — $11.1bn — has been denominated in US dollars, with Canadian dollars close behind at $8bn.

CPPIB has been by far the most active pension fund in the capital markets to date, having raised nearly $12bn in debt before today, according to Dealogic data.

Canada’s Public Sector Pension Investment Board, the Ontario Pension Board and the Ontario Teachers’ Pension Plan have all also tapped the bond markets in the past four years.

Pension funds are required by regulators to hold large volumes of highly rated, ultra-safe debt. This has proved challenging for their returns targets in recent years as yields on these investments have lurked around historic lows, thanks to the era of ultra-expansionary monetary policy.

As a result infrastructure and private equity have become popular investment areas for funds which are lured by the relatively high yields these areas can offer.

Now, funds are adding leverage to the mix, too.

In a 2017 presentation to investors CPPIB said, that debt issuance “allows CPPIB to benefit from our standalone AAA/AAA ratings”, gives the fund a “better tailoring of risk profile via selective leverage” and “prudent liquidity management provides CPPIB with the flexibility to invest in dislocated/distressed markets”.

CPPIB’s underlying fund has net assets of $337bn; its board has approved plans to raise up to CA$25bn of bonds in total.

The same presentation tells bondholders that, in the event of any cash flow issues, they will take precedence over pensions savers.

“CPPIB cannot be required to transfer amounts to fund CPP benefits if, after any such transfer, CPPIB would not be in a position to meet all of its obligations including under the Notes [ie. bonds],” it says.

The largest holders of CPPIB’s outstanding bonds are central banks and other official institutions, which hold more than a third of each of its issues according to figures included within the presentation.

Bank of America Merrill Lynch, BNP Paribas, Deutsche Bank and JPMorgan acted as bookrunners for CPPIB.
You can read CPPIB's presentation on debt issuance here.

I've already discussed why Canada's pensions are piling on the leverage here and followed up with another comment on Canada's highly leveraged pensions here.

There are many misconceptions about Canada's large pensions and their use of leverage and to what extent they're leveraging up their portfolio to address the real challenge of a low rate, low return world.

Let me try to address some myths and stick to the facts on the use of leverage at Canada's large pensions.

First, it's definitely true that Canada's large pensions leverage up their portfolio and some do it  a lot more than others. It's not just about issuing debt, some pensions (like HOOPP and OTPP) use extensive bond repos to leverage up their fixed income portfolio or swapping into fixed income indexes to invest in hedge funds (portable alpha strategy).

But whatever the case, it's critically important to understand two things:
  1. Canada's large pensions have the governance to hire very talented individuals who understand derivatives and how to engage in very sophisticated trades that may seem risky to an outsider but in reality is an efficient and conservative use of capital
  2. Canada's large pensions have a successful long-term track record, they're fully-funded which allows them to get a AAA credit rating from the rating agencies to go out and issue debt to invest across public and private markets all over the world. Again, this is an efficient use of capital, much like a corporation that issues debt to invest in new plant equipment. 
I think it's critically important to keep these two points in mind when it comes to Canada's pensions leveraging up their portfolio. They're doing so because a) they have the balance sheet and long-term track record to do so and b) they know what they're doing and investing wisely and c) their interests are perfectly aligned with those of their members.

It's also worth noting that when structured carefully and inteligently, increasing leverage can reduce the overal risk of the portfolio (think about risk parity strategy done internally).

The only criticism I have when it comes to using leverage is that Canada's pension overlords get compensated extremely well which is fine given their long-term success and expertise, but at one point leverage has to be factored into the equation when it comes to benchmarks and compensation.

To make my point, let’s say I have a choice to invest in two hedge funds, similar strategies, but one is employing twice the leverage of the other. Even though they have better returns, I have to adjust my expectations and take into account the leverage they're using because if markets tank, the one using more leverage will suffer bigger losses.

Again, it's not as simple for Canada's large pensions because they're not always using directional leverage but leverage is leverage and we need to keep in mind some of Canada's large pensions use leverage more liberally than others.

The problem is they're not all transparent about it. If it were up to me, I'd change legislation to force them to have a dedicated section in their annual report explaining in detail their use of leverage. No exceptions, spell it out clearly a bit like CPPIB did in that presentation which by the way they need to do by law to issue debt. They all do but what I want is something much more clear and part of the annual report.

Below, Warren Buffett, quoting partner Charlie Munger, says there are three ways to go broke: 'liquor, ladies and leverage'. He's right for individuals taking out home equity loans or any loan to buy stocks but he's not right when it comes to major institutions like Canada's large pensions which know how to intelligently leverage up their portfolio to make efficient use of their capital, seizing opportunities as they arise. I think Buffett would agree with me on that point.

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