Canada's Pensions Squeezing Blood From Fixed Income Stones?

Blake Wolfe of Benefits Canada reports on how Canada’s pension funds are maximizing fixed income in a low interest rate environment. 

You can read the full article here but let me skip to the pension section:

David Ross, managing director of the capital markets group at the OPSEU Pension Trust, says the plan is approaching fixed income cautiously. In 2020, it significantly reduced fixed income exposure by cutting nominal bond exposure in half.

“It really didn’t make a lot of sense to hold that same level of bonds. They served us well historically as a liability and risk mitigant, but given the asymmetric return profile moving forward and the global backdrop, the prudent thing to do was to reduce that exposure. I don’t see that allocation changing much this year, but yields have backed up in the first quarter and my expectation is that we still have some upside for yields given the backdrop. We still hold some bonds and we’ll look to reintroduce more when we feel the risk/reward ratio is better for us.”

While the OPTrust’s bond exposure is predominantly within developed markets, Ross sees opportunities within the credit space in emerging markets — particularly within loans and structured credit, which are accessed through external managers — in industries poised to recover from an economic reopening, such as transportation, basic materials and industrials.

“The portion they’re running against our benchmark is positioned a bit defensively. They’re avoiding duration given what’s been going on with the underlying nominal bonds and they’ve focused on sectors that they expect to benefit from the recovery of economic activity this year. There’s a bit of a dual approach there – being defensive while also being opportunistic for those sectors that have been beat up [by the pandemic].”

Jérôme Marquis, managing director and head of corporate credit at the Caisse de dépot et placement du Québec, says the pension fund is continuing a diversified fixed income strategy that began in 2016. Instead of increasing fixed income returns through additional risk taken on in its bond portfolio, he says the Caisse leveraged its flexibility and investment expertise to generate returns through private debt, including through premiums stemming from liquidity and complexity.

While the pension fund’s private debt allocation was approximately $16 billion at the end of 2016, he says that amount more than doubled to $35 billion at the end of 2020 and is on track to reach $50 billion over the next two to three years.

We took that route because when you’re flexible, [invest] long term and have expertise, you can generate more returns by not necessarily taking more risk, but through liquidity premiums. You want flexibility as a company? I’ll give you flexibility — but you’ll pay for it. If you come to us and it’s complicated, because of the teams some pension funds have, we can implement a solution that might not be accessible through the public market. Ultimately, we’ll get a premium because it’s complicated. I’m not increasing my risk, I’m just playing on the liquidity premium and the flexibility I’m providing to companies.”

In addition to increased private debt allocations, the Caisse also created a capital solutions group in 2017 to generate innovative solutions through what Marquis describes as hybrid approaches that are outside of typical classifications of equities or debt, including royalties and the monetization of cash flows.

“Their role is to provide innovative solutions through products not accessible to everyone, because you need creative people to find these solutions. But we’re [a] long-term [investor] and have expertise so you can generate returns not necessarily by taking on more risk but by providing innovative solutions. . . . We’ve built a well-diversified credit portfolio, with corporate, real estate, infrastructure and a bit of leveraging markets. But the majority of growth is coming from private debt strategies and the capital solutions group.”

While the early stages of the pandemic forced the Caisse to play defense and review its credit portfolio, Marquis says its long-term strategy remains the same, with a focus on investments in stable sectors including health care and software.

“We’re lucky we weren’t in the most affected sectors. You’ve got to choose well and it’s key in credit to review your portfolio. Once that work was completed, we started to play offense again. Now markets have returned, capital is there and the market is active so it’s more competitive.”

Excellent article discussing how some of Canada's large pensions are addressing record low yields in fixed income market.

There's no magic recipe to boost yields in fixed income. Either you take more duration risk, more credit risk or more liquidity risk. You can also take on leverage to juice returns.

For the longest time, Canada's large pensions were taking on more credit risk but since spreads are now at record lows, they added private debt to their fixed income arsenal. 

I've discussed pensions love-hate relationship with private debt, the key points are below:

This TIAA paper explains the attractiveness of private debt to institutional investors:

  • Private debt has emerged as an asset class addressing institutional investors’ search for yield and lower volatility amid record-low interest rates and market uncertainty.
  • Structural changes in fixed-income markets—decreased liquidity and rising asset correlations—are increasing investors’ willingness to trade liquidity for yield.
  • Banks pulling back from the middle market have created opportunity for non-bank asset managers to issue direct loans to below-investment-grade companies at higher interest rates.
  • Among private debt categories, middle market senior loans and mezzanine debt historically have offered particularly attractive risk-adjusted returns as potential substitutes for traditional assets, including high-yield bonds and equity.
  • The private debt market’s complexity requires due diligence in selecting experienced asset managers with a record of success in creating diversified private loan portfolios.
Now, in Canada, some pension funds are very active in private debt.

CPPIB, for example, has roughly C$40 billion in credit investments, with around 80% of that speculative grade. This includes corporate, real estate and structured deals.

John Graham is in charge of CPPIB's giant credit portfolio and he stated this to Bloomberg last year:
CPPIB remains bullish on the U.S. middle-market, where it invests through Antares Capital, which has about $24 billion in assets. Antares is prepared to swoop in to buy assets from cash-strapped lenders when the cycle turns, its chief executive officer said in July.

“We really do try to get deep diligence on every single deal,” Graham said. He added that CPPIB sees good opportunities to invest in companies that will survive a downturn in the credit cycle. 
No doubt the COVID crisis presented great opportunities to CPPIB and others but the problem which was stated in the article at the top is the Fed and US government came in to quickly calm markets and spreads tightened again very quickly.

Private debt, however, is no panacea. You take on liquidity risk to be part of this asset class and default risk too which is why you need to structure a very diversified portfolio.

By the way, during a crisis, liquidity vanishes in the fixed income market, you've seen this during the 2008 crisis and during March of last year when the pandemic broke out.

No liquidity means nothing was trading except for government bonds. Forget about using leverage, repo markets still functioned well but you couldn't emit bonds during the crisis.

Of course, Canada's large pensions don't need liquidity all the time and they can weather a storm but I am just giving you some thoughts as to why private debt is no panacea.

And competition is fierce, spreads are collapsing. CPP Investments' CEO John Graham recently told me they see opportunities in structured credit but other segments of the market are "richly valued" (read: no room for error).

But with government bond yields at record lows, fixed income departments are forced to take on risks elsewhere in the capital structure, and private debt fits well into the asset mix of large pensions with long dated liabilities.

The only point I am making is you're taking on liquidity and default risk when you allocate more into private debt and you need to manage both these risks very carefully because when a crisis hits, liquidity vanishes very quickly and default risk skyrockets. 

The good news is one way or another, this new delta variant will speed up herd immunity and we can get on with the economic recovery:

But what worries me is the endgame and how the Fed will retract all that liquidity in markets and how it will impact credit markets. 

All that remains to be seen, for now, Canada's large pensions are maximizing their fixed income returns and doing a great job at it. 

Below, Jérôme Marquis, managing director and head of corporate credit at CDPQ, and Neuberger Berman's co-head of private credit Susan Kasser, discuss the evolving debt terms in the $890 billion alternative lending market. They speak to Bloomberg's Lisa Lee as part of the virtual event "What’s Next for Private Credit After the Pandemic?"