Unlocking the Value in Pension Plans

Transcription

1 JANUARY 214 Global Fixed Income: Unlocking the Value in Pension Plans MATTHEW WILLIAMS, MBA, MCOM Vice President, Defined Contribution Strategy JULIE CARON, CFA Senior Vice President, Institutional Investment Services TERRY KIRBY, CFA Senior Vice President, Institutional Investment Services This information is intended solely for institutional investment management consultants interested in Franklin Templeton institutional investment advisory services. Various account minimums or other eligibility qualifications apply depending on the investment strategy. This material is not an offer to buy or sell securities or an offer of investment advisory services and is not intended to be, nor should it be used as, investment advice; it may be copied or distributed without the prior written consent of Franklin Templeton Investments. Opinions expressed are current opinions as of the date appearing in the material only. The services described herein would be provided to insurance companies or accounts of, or affiliated with, insurance companies; such services would not provide any insurance or guarantee for the subject asset principal value will fluctuate and may be lost. All investments are subject to risks, and investment strategies may not achieve the desired results. Investments with greater potential for return typically have more risk. The low-yield, low interest-rate environment of the past several years continues to weigh on the ability of plan sponsors to fund liabilities. Fixed income investments have traditionally been used in pension plans primarily as a hedge against liabilities, but plan sponsors are looking for ways to ensure investment returns keep pace with solvency liability growth. Increasingly, they are restructuring the fixed income allocation of their plan portfolios not only for protection of capital, but also as a potential source of risk-adjusted returns. We believe expanding fixed income exposure to include foreign investments such as global bonds, emerging market debt and international high-yield securities can effectively address two of the most pressing investment challenges in most Canadian pension plans today: the need for diversification and pursuit of higher yields. Compared to the domestic fixed income market, non-canadian markets offer: More numerous and more liquid fixed income securities, including investmentgrade global and regional bonds, high-yield bonds, leveraged bank loans and derivatives; The potential for relatively higher real yields without added term risk, particularly in emerging markets; and Opportunities to generate excess returns, or alpha, through active management of portfolio duration, yield curve exposure and sector allocation. In our view, foreign fixed income investments are well suited to the requirements of retirement investing and deserve representation in most pension fund portfolios. This paper sets out our perspective of the opportunities, the risks, and how we address them. No Place like Home? Not Necessarily The Pension Investment Association of Canada reports that, at the end of 212, member DB plans had allocated an average 32% of their portfolios to fixed income investments. Only 1.5% of that amount, however, was directed to foreign fixed income Pension Investment Association of Canada, Composite Asset Mix Reports, 212

2 2 Plan sponsors cite numerous reasons for this home bias, mostly revolving around liability matching, currency concerns and risk. An unswerving focus on the home market, however, carries its own risks. Matching liabilities by maintaining higher exposure to domestic bonds can help protect a portion of the portfolio, but inadequate liquidity and overreliance on short-maturity interest rate exposures, which are characteristic of the Canadian fixed income market, create a less than optimal match for long-term liabilities. Accounting for only 3% of the global fixed income market, the Canadian bond market is highly concentrated in federal and provincial government bonds, which tend to have lower yields than both government bonds of many other countries and corporate bonds. Though the market for corporate bonds has experienced robust growth since 28, it continues to represent a much smaller proportion of the domestic fixed income market as a whole and is heavily overweighted to certain sectors (primarily financials). Security selection is dominated by investment-grade securities and spreads are relatively narrow, which leaves little opportunity to add value. In contrast, the tradable global fixed-income market is approximately US$1 trillion 2. Fixed income issuance and the variety of available investments outside Canada are both more numerous and more liquid, with a readily available supply of investment-grade global and regional bonds, high-yield bonds, leveraged bank loans derivatives. With over 1 countries around the world having partially or fully functioning capital markets, the inclusion of foreign markets automatically broadens the investable universe (Figure 1). Because the world s best-performing markets can vary considerably from year to year, diversification increases the likelihood of consistently capturing their higher returns. Being invested in several different markets also strengthens the portfolio manager s ability to act tactically in changing market conditions, potentially reducing volatility. Figure 1: Broadening the Investable Universe Expanding Opportunity Set Total Government Debt Outstanding: US$44.5 trillion* As of March Debt Outstanding (trillions of U.S. dollars) Developing Developed ex-g3 G3 Number of Countries US$34.6 tn US$4. tn US$5.9 tn Number of Countries Available for Investment *Note: Excludes international organizations and offshore financial centers. Total is equal to US$54.7 trillion, as of March 212. Source: Bank for International Settlements, Securities Statistics and Syndicated Loans, September 212. Charts are for illustrative and discussion purposes only. 2. Source: Bank for International Settlements, March 212

3 3 Global foreign exchange markets encompass the world s most liquid currency markets, providing opportunities to hedge risk and benefit from currency appreciation, particularly in developing countries. (Figure 2). Figure 2: Advantages of currency diversification Currency Markets Are the Most Liquid in the World Average Daily Turnover of Global Foreign Exchange Market in April 1 From April 1998 through April 21 (USD BIillion) 6, 5, 4, 3, 2, 1, Apr 98 Apr 1 Apr 4 Apr 7 Apr 1 Apr 13 Spot Forwards Other Source: Bank for International Settlements - International Banking Statistics, April 213. Risks and the Reality As the search for higher total return intensifies, so does the challenge of maintaining quality. Concerns about foreign market risks surrounding credit, currency and interest rates, among others, have constrained pension fund managers from venturing into non-traditional fixed income securities. Investing in foreign fixed income does involve certain specific risks, including the potential for currency fluctuations, economic instability and adverse political developments. Within the universe of global investments, however, markets vary widely. Overall, the global bond market s weighting to triple-a bonds is similar to that of Canada 3. Effective risk management is inextricably entwined with the quality of resources devoted to credit research and comprehensive macroeconomic analysis. As with other types of global investing, independent due diligence supersedes the traditional reliance in Canada on the dealer market. When selecting an asset manager for non-traditional fixed income, plan sponsors should ensure risk analysis and ongoing risk oversight are integrated into every step of the investment process. Emerging Market Debt: A Turnaround Opportunity One of the great success stories of the past decade has been the vibrant economic growth of the emerging markets, much of which has been financed by local and foreign investors through fixed income instruments. The current market value of tradable emerging-markets bonds is approximately US$3.3 trillion. The market consists primarily of sovereign external debt, sovereign domestic debt, and quasi-sovereign and private external debt. (Emergingmarket corporate domestic bonds are broadly inaccessible to foreign capital at this time.) New and evolving emergingmarkets fixed income assets include structured finance (e.g. securitization of receivables), infrastructure bonds, municipal debt, interest-rate swaps, credit-linked notes and forward-rate agreements. Increasing economic prosperity has been accompanied by lower debt-to GDP ratios. At the end of 212, general government indebtedness in developed economies was an average of 17.9% of GDP, compared with just 35.5% of GDP in emerging markets 4. In many developing countries today, solid foreign exchange reserves to short-term external debt ratios have resulted in some emerging market sovereign bonds being more creditworthy than those of developed markets. Although higher-yielding bonds are generally viewed as being accompanied by a higher default risk, opportunities exist in emerging market investments for yield pickup between bonds with the same rating or credit risk. The potential ability to obtain relatively higher real yields without added term risk furthers the case for investment in this asset class. Historically, less efficient markets have presented excellent opportunities for exposure to high real yields, potential currency gains and, in some cases, sounder sovereign balance sheets than developed countries through both hard and local currency issuers. Local currency debt in many developing countries is becoming more investment grade. In the hands of a skilled manager, currency hedging strategies can become a potential source of alpha. 3. Source: FactSet[a], DEX Universe Bond Indices[b], Barclays[d]. See page 7 for full footnotes. 4. Source: IMF World Economic Outlook Database, October 213. Copyright (c) 213. By International Monetary Fund. All Rights Reserved.

4 4 Investing in emerging market debt requires an awareness of possible limitations engendered by relatively smaller size, lesser liquidity and lack of established legal, political, business and social frameworks necessary to support securities markets. Mispricing in these markets is commonly caused by excess demand over supply. Although emerging market currencies have generally appreciated along with economic development, currencies of countries that still depend to a large extent on developed markets for funding may be more vulnerable to pullbacks unrelated to their domestic economies. Nevertheless, investor demand for emerging market debt has rapidly expanded, and the market has responded with increased supply. At the end of November 213, some US$843 billion of emerging-markets foreign bonds had been issued, much of which was taken up by foreign investors, as shown in Figure 3. Figure 3: Foreign investors embrace local currencies Percent of total /2 12/2 3/3 12/3 3/4 12/4 3/5 12/5 3/6 12/6 3/7 12/7 3/8 12/8 3/9 12/9 3/1 12/1 3/11 12/11 3/12 12/12 3/13 12/13 Thailand Indonesia Malaysia Korea Australia UK US Hungary Poland Turkey Mexico Source: National sources (Asian Development Bank: Thailand, Indonesia, Malaysia, Korea; Australia Bureau of Statistics; UK Debt Management Office; US Treasury; Central Bank of Hungary; Poland Ministry of Finance; Central Bank of the Republic of Turkey; Banco de Mexico). High Yield Bonds: A Developed Market Opportunity From the perspective of liability driven investment, highyield fixed income investments are slotted into the asset allocation bucket (as opposed to liability hedging) due to their duration properties. Canadian plan sponsors tend to devote few resources to high yield, possibly because of discomfort surrounding high levels of concentration in the domestic market and bias toward more equity-friendly capital structures. Currently, one of the more attractive high-yield markets is in the US familiar, liquid, and with the advantages of manageable currency and duration exposure. Over the past 1 years, the US high-yield market has grown sharply from $225 billion to over $1.3 trillion (figure 4).

5 5 Figure 4: A Significant and Growing Asset Class High-Yield Market Growth (USD) High-Yield Market Size (US$ bn) New Issue Volume, (US$ bn) New Issue Volume, $ Billions High Yield Market Size Source: JP Morgan As of December 31, 212 Past performance does not guarantee future results and results may differ over future time periods. THE HIGH-YIELD MARKET HAS GROWN SHARPLY OVER THE PAST DECADE INTO AN OVER $1.3 TRILLION MARKET VERSUS A MORE THAN $7.1 TRILLION MARKET FOR INVESTMENT-GRADE CORPORATE BONDS. To exploit valuation inefficiencies across the highyield market, strategies may focus on single sectors, non-investment grade securities, single-sector high yield, or high-yield alternative vehicles, among others. Security selection, sector allocation, portfolio structure, benchmark analysis and new issue analysis are all important aspects to consider and may involve top down, bottom up and quantitative analysis. Given the inherent risks, high yield investing is usually left to specialists. Alpha Generation: An Active Pursuit Alpha from fixed income sources has tended to be bypassed in Canada in favour of equities and other higher-volatility investments, but it is receiving increasing attention as a potential source of improved returns. Independent sources of alpha can be generated from almost any aspect of fixed income: duration, foreign exchange, and sovereign ideas; macro themes; sector ideas, and sub-sector/security selection ideas. Portfolio managers commonly employ relative value tools in optimizing portfolios. Research often produces multiple possibilities such as quantitative credit modeling (default and recovery), capital structure opportunities (loan, bond, convertible, preferred, hybrid, equity), credit curve dynamics, long-short basis opportunities, credit derivative and hedging strategies, and loan prepayment models. Since asset managers typically do not invest in all generated ideas, in our view the ability to not only determine the most suitable strategies for the circumstances, but also act tactically upon them, is essential for optimal alpha capture. We believe the most effective way to generate alpha from fixed income investments is through active management of portfolio duration, yield curve exposure and sector allocation. Active managers can exploit opportunities resulting from both positive and negative developments in currencies, interest rates and credit. In our view, a manager with the experience and ability to navigate through different market environments, including rising interest rates and down markets, may be able to manage downside risk.

6 6 Our Approach to Risk Management: Recognized, Rational, Rewarded Drawing on the resources of one of the world s largest global fixed income research platforms, our in-house risk management team is focused on ensuring that the potential risks associated with global investing and foreign currency exposure are recognized at the security, portfolio and operational levels, rational an intended and rational part of each portfolio s strategy and rewarded with commensurate long-term reward potential. We use industry standards, proprietary models and macroeconomic analysis, as well as an integrated system of ongoing portfolio review, to precisely isolate expected returns from desired risk exposure. Risk budget composition will shift based on relative attractiveness during global economic credit cycles. Our tools and strategies include: Cross-hedging to alleviate currency risk Risk toolkits, including VaR (Value at Risk)/Correlations/ Conditional VaR, tracking error, standard deviations, semi-standard deviations, Sharpe ratios and others Scenario analysis and stress testing to determine a port folio s sensitivity to various risk scenarios Risk oversight: monitoring for compliance and corporate investment expectations, including pre-trade compliance, daily risk monitoring, complex securities review committee, counterparty risk reports and formal internal audits. Launch Satellite We believe global fixed income investments hold significant potential to improve total return by addressing all aspects of curve, currency and credit. In the presence of stringent due diligence and comprehensive risk management procedures, it is our view that the risks inherent in foreign investment are manageable and that the potential rewards are commensurate with the risks. Determination of component size and strategies for integration into existing fixed income portfolios should reflect the unique circumstances of the pension plan. Plan sponsors are demonstrating a preference for core/satellite allocation, although non-traditional fixed income can be deployed in a standalone capacity as well. Canadian pension plans took almost two decades to move into global equities but today, virtually all have some degree of exposure. With the world still deleveraging from the 28 financial crisis, numerous investment opportunities are available in fixed income markets outside Canada. As plan sponsors actively seek out additional potential sources of yield and higher total return, we expect asset allocation toward non-traditional fixed income investments to play an ever more important role in Canada s defined benefit and defined contribution pension plans.

7 7 IMPORTANT NOTES Footnote 3: a. Source: FactSet: 213 FactSet Research Systems Inc. All Rights Reserved. The information contained herein: (1) is proprietary to FactSet Research Systems Inc. and/ or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither FactSet Research Systems Inc. nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. b. Source: PC-Bond, a business unit of TSX Inc. Copyright TSX Inc. All rights reserved. The information contained herein may not be redistributed, sold or modified or used to create any derivative work without the prior written consent of TSX Inc. c. Source: Barclays Global Family of Indices. 213 Barclays Capital Inc. Used with permission. J.P. Morgan is the marketing name for JPMorgan Chase & Co., and its subsidiaries and affiliates worldwide. Franklin Templeton Products are not sponsored, endorsed, sold or promoted by J.P. Morgan. J.P. Morgan Government Bond Index Global (LCL) is created based on stated, established rules. The creation or use of J.P. Morgan Government Bond Index Global (LCL) does not constitute a recommendation by J.P. Morgan of Franklin Templeton Products or a trade recommendation by J.P. Morgan. J.P. Morgan makes no representation or warranty, express or implied, with respect to Franklin Templeton Products, or the advisability of investing in securities generally, or in Franklin Templeton Products particularly, or the ability of J.P. Morgan Government Bond Index Global (LCL) to track bond market performance. J.P. Morgan has no obligation to take the needs of the prospective purchasers or owners of the Franklin Templeton Products into consideration in determining, composing or calculating J.P. Morgan Government Bond Index Global (LCL). J.P. Morgan is not responsible for and has not participated in the determination of the timing of, prices at, or quantities of Franklin Templeton Products. J.P. Morgan has no obligation or liability in connection with the administration, marketing or trading of Franklin Templeton Products. J.P. Morgan Government Bond Index Global (LCL) IS PROVIDED AS IS WITH ANY AND ALL FAULTS. J.P. MORGAN DOES NOT GUARANTEE THE AVAILABILITY, SEQUENCE, TIMELINESS, QUALITY, ACCURACY AND/OR THE COMPLETENESS OF J.P. Morgan Government Bond Index Global (LCL) AND/OR ANY DATA INCLUDED THEREIN, OR FROM ANY USE OF J.P. Morgan Government Bond Index Global (LCL). J.P. MORGAN MAKES NO EXPRESS OR IMPLIED WARRANTIES, AND HEREBY EXPRESSLY DISCLAIMS ALL WARRANTIES OF MERCHANTABILITY OF FITNESS FOR A PARTICULAR PURPOSE OR USE WITH RESPECT TO J.P. Morgan Government Bond Index Global (LCL) OR ANY DATA INCLUDED THEREIN, OR FROM ANY USE OF J.P. Morgan Government Bond Index Global (LCL). THERE ARE NO REPRESENTATIONS OR WARRANTIES WHICH EXTEND BEYOND THE DESCRIPTION ON THE FACE OF THIS DOCUMENT, IF ANY. ALL WARRANTIES AND REPRESENTATIONS OF ANY KIND WITH REGARD TO J.P. Morgan Government Bond Index Global (LCL), ARE DISCLAIMED INCLUDING ANY IMPLIED WARRANTIES OF MERCHANTABILITY, QUALITY, ACCURACY, FITNESS FOR A PARTICULAR PURPOSE AND/OR AGAINST INFRINGEMENT AND/OR WARRANTIES AS TO ANY RESULTS TO BE OBTAINED BY AND/OR FROM THE USE OF J.P. Morgan Government Bond Index Global (LCL). WITHOUT LIMITING ANY OF THE FOREGOING, TO THE FULLEST EXTENT PERMITTED BY LAW, IN NO EVENT SHALL J.P. MORGAN HAVE ANY LIABILITY FOR ANY SPECIAL, PUNITIVE, DIRECT, INDIRECT, OR CONSEQUENTIAL DAMAGES, INCLUDING LOSS OF PRINCIPAL AND/OR LOST PROFITS, IN CONNECTION WITH J.P. Morgan Government Bond Index Global (LCL) AND/OR Franklin Templeton Products EVEN IF NOTIFIED OF THE POSSIBILITY OF SUCH DAMAGES.

8 IMPORTANT LEGAL INFORMATION This article reflects the analysis and opinions of the author as of December 31, 213, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided are valid only as of December 31, 214. The commentary does not provide a complete analysis of every material fact regarding any country, market, strategy, industry or security. An assessment of a particular country, market, security, investment or strategy may change without notice and is not intended as an investment recommendation nor does it constitute investment advice. Statements about holdings are subject to change. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Franklin Templeton Investments Corp. 2 King Street West, Suite 15 Toronto, ON M5H 3T4 (8) Franklin Templeton Investments. All rights reserved. In Canada, Franklin Templeton Institutional is is part of Franklin Templeton Investments Corp. FIX INWPE 2/14