UNCONSTRAINED FIXED INCOME FOR HEALTHCARE INSTITUTIONS

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1 DECEMBER 2017 UNCONSTRAINED FIXED INCOME FOR HEALTHCARE INSTITUTIONS AT A GLANCE } In a market climate that calls for healthcare institutions to take new approaches, unconstrained fixed income strategies can be a versatile tool across asset pools. Ned Rosenman Foundation, Endowment, and Healthcare Client Specialist Shayan Hussain, CFA Senior Product Strategist, Global Fixed Income Gargi Chaudhuri Senior Product Specialist, Global Fixed Income } By targeting a diverse and changing opportunity set, unconstrained fixed income seeks to deliver returns across different market environments with low correlations and low volatility making it a potential diversifier for a core fixed income portfolio. } Unconstrained fixed income may also be useful for investors seeking to improve returns on medium-term cash holdings, or to add diversification and downside mitigation to longer-term portfolios. Hospitals and healthsystems in the U.S. are currently facing a number of challenges. These include doubts around future ACA-related revenue streams, increased pressure on state budgets, rapidly increasing labor and pharmaceutical costs, and the rising cost of capital for debt-issuing institutions. The net result is that hospital expenses are now rising faster than revenues, putting significant pressure on margins. See the Rising costs chart. As a result, there is increased pressure on the finance divisions of these entities to earn more from their investment portfolios, particularly in light of the low projected return environment. But the investment returns from fixed income are under threat from rising interest rates. In healthcare institutions shorter-term asset pools, liquid cash vehicles, which are often used to invest operating and medium-term funds, offer scant returns. Longerterm pools, including pension assets and endowment or depreciation allocations, may benefit from diversifying equity risk, without adding incremental volatility or sacrificing liquidity. RISING COSTS Average annual revenue and expense growth for median U.S. nonprofit healthcare systems % Annual Median Revenue Growth Annual Median Expense Growth Operating Margin Source: Moody s Investor Service, December U.S. not for profit hospital financial performance. MARKET S INVESTMENT ACTIONS PORTFOLIO DESIGN RISK MANAGEMENT REGULATORY

2 DIVERSIFYING RETURNS Return drivers for the Bloomberg Barclays U.S. Aggregate Index and SIO composite Supplemental information Bloomberg Barclays US Aggregate Index drivers of return BlackRock SIO portfolio drivers of return US rates Spread return Duration IG credit High yield ABS CMBS Non agcy CLOs Munis US absolute return European credit Asia credit Emerging markets Macro Global Source: BlackRock, September Charts represent the performance attribution of the Index and the SIO composite from March 2010 through September March 2010 is the strategy inception date. See Page 5, BlackRock Strategic Income Opportunities composite, for related GIPS compliant data. It s a climate that calls for new approaches, and investors have responded accordingly. One non-traditional strategy that we have seen find favor with healthcare institutions is unconstrained fixed income, a liquid absolute return strategy that can be employed across a variety of their asset pools to help meet some diverse challenges. We discussed the strategies in a similar paper released earlier this year, and we believe the specific applicability to healthcare systems warrants a deeper look. Unconstrained fixed income seeks to diversify the sources of return and to control volatility versus traditional fixed income strategies by investing dynamically across a range of sub-strategies including investment grade, high yield, international and emerging market debt, municipal bonds and CLOs, on an opportunistic basis. See the Diversifying returns chart. The strategy aims to provide investors with widely diversified alpha streams across fixed income, targeting broad diversification with low downside risk and low correlation to interest rates and other directional market exposures. Unconstrained fixed income is benchmark-agnostic and has historically been used with the goal of buttressing core bond portfolios against sharper-than-expected rate rises in a landscape where the yield versus duration tradeoffs have changed significantly. Applications have broadened, however, as investors seek out strategies that may dampen volatility in their portfolios while potentially adding returns in diverse market environments. Meanwhile, fixed income markets have undergone significant changes over the last decade, helping to spur adoption of unconstrained fixed income strategies. In the post-financial crisis years, duration has extended and yields have declined in the major government bond markets, while higher returns have tended to be available only in concentrated sectors. For core strategies benchmarked to indexes dominated by government and investment grade bonds, returns have gone down while the risks posed by potential rate increases have gone up. Unconstrained strategies seek to take advantage of a wider range of potential investments and, in the case of BlackRock s Strategic Income Opportunities (SIO) strategy, to do so in a risk-aware, volatility-managed manner. In our April 2017 paper, Diversifying the core: Unconstrained fixed income in an uncertain world, we showed how including an allocation to the SIO composite in a hypothetical core bond portfolio would have reduced volatility and improved returns over the past five years. Our unconstrained fixed income strategy proved useful in this context because of its low volatility, low correlations and potential to deliver absolute returns in a cost-effective manner. We have also seen SIO serve as a possible solution for a variety of healthcare-system investment needs, and we outline some of these here. OPERATING CASH AND INTERMEDIATE- HORIZON CAPITAL In today s low-return climate, the performance drag from cash holdings with a medium-term time horizon is especially 2

3 STEADY AS SHE GOES Average returns of the SIO composite, Bloomberg Barclays U.S. Aggregate Index, and nontraditional bond funds across different interest rate environments Supplemental information Rising rates Flat rates Falling rates BlackRock SIO (Net) BBG Barclays US Aggregate Index Nontraditonal bond category Source: Morningstar Direct, September Past Performance does not guarantee future results. Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Rate Periods: Sorts through daily 10-year treasury rates from 12/31/2010-9/30/2017. Rising Rate Periods (10): Counts period if <= 60 day period with at least a 40 basis point (bp) increase in the 10-year Treasury rate from start date to end date. Overlapping periods are eliminated by choosing the period with the highest rate increase. Flat Rate Periods (14): Ending date rate must be within +/- 2 bps of start date rate. Period must be at least 30 days and no more than 90 days (business days). Variance of rate in the periods must be +/- 15 bps from start date rate on each date over the period (ensures minimal volatility over the period as a whole). Overlapping periods are eliminated by choosing the period with the longest date range. Declining Rate Periods (12): Counts period if <=60 day period with at least a 40 bp decline in the 10-year Treasury rate from start date to end date. Overlapping periods are eliminated by choosing the period with the largest rate decrease. See Page 5, BlackRock Strategic Income Opportunities composite, for related GIPS compliant data. acute. Yet, relative to other non-profit investors, healthcare institutions are often obliged to hold a significant amount of lower-risk, short-term assets to maintain operating capital for expenses and to help support credit and balance sheet quality. It s not unusual for a hospital or health system to have $100 million or more in operating capital that must remain liquid, but on which the institution needs to earn a return. In addition, the unpredictable nature of large philanthropic gifts can create sizeable cashflows that need to earn returns while capital is put to work. In both cases, generating additional return may involve adding duration or credit risk. But doing so without sacrificing too much principal protection poses a challenge, given current fixed income valuations. Under these circumstances, an unconstrained fixed income strategy could be an attractive option, provided it can pass the crucial test of low volatility and consistency of returns. In our view, the key to targeting this kind of performance is avoiding concentrated bets and instead focusing on a wide array of incremental return opportunities. The approach calls for seeking out duration and credit exposures wherever they appear most attractive, adjusting the level and sourcing of each as conditions change. With monetary policy increasingly diverging around the globe the European Central Bank and the Bank of Japan are still in the midst of quantitative easing while the U.S. Federal Reserve has already raised rates twice this year and signalled further increases to come we anticipate continued opportunities for a dynamic strategy with this profile. Tapping diverse and changing sources of return has helped the SIO strategy deliver consistent returns in a variety of interest rate environments. See the Steady as she goes chart. For healthcare systems with self-insurance pools, clients are increasingly aware of the ability (and need) to take additional credit risk beyond treasury capital. In such cases SIO may potentially improve returns on medium-term cash holdings and help mitigate principal risk. It should be noted that the strategy s currently low duration another necessary characteristic for using it this way may eventually increase from its level of 1.67 years at the end of October 2017, if and when market conditions require. The strategy s duration band is -2 to +7 years, however it has historically operated between 0 and +3 years. IN AN ABSOLUTE RETURN CAPACITY Healthcare providers with significant return needs in their defined benefit, endowment, or deprecation assets have often used hedge funds as part of their strategy to help reach investment goals. Hedge funds have drawn plenty of scrutiny in recent years, with particular attention paid to their underperformance of equity indexes. In response, many investors have redoubled their focus on why they own hedge funds in the first place, putting fresh emphasis on their 3

4 SIO COMPOSITE VS. HFRI WEIGHTED COMPOSITE INDEX Annualized return, volatility, betas, and correlations, March 2010 September 2017 Supplemental information RETURN/VOLATILITY 5% Return Standard deviation BETA (MAGNITUDE) US Agg S&P 500 HY CORRELATION (DIRECTIONALITY) US Agg S&P 500 HY SIO HFRI SIO HFRI SIO HFRI Sources: Morningstar, BlackRock, hedgefundresearch.com, September Data from March 2010 to September 2017 for the strategy composite. These charts show characteristics of BlackRock SIO composite vs. the HFRI Weighted Composite Index, the S&P 500 Index and the Bloomberg Barclays U.S. High Yield Index. See Page 5, BlackRock Strategic Income Opportunities composite, for related GIPS compliant data. Data may be subject to revisions from time to time based on availability of new information. Any such revisions are not material. The composite comprises BlackRock fixed income strategies that are fully discretionary, unconstrained total return fixed income portfolios and have the flexibility to invest across all fixed income asset classes and manage duration within a risk controlled framework. These strategies have at least $50 million in assets and are not actively managed to a specific benchmark. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in US Dollar and have a minimum of $50 Million under management or a twelve (12) month track record of active performance. The HFRI Fund Weighted Composite Index does not include Funds of Hedge Funds. potential to deliver absolute returns and provide a measure of downside mitigation to a portfolio. Investors have also taken a hard look at the fees many hedge fund managers charge, weighing them against the benefits achieved. Count us among those who would caution against a simplistic dismissal of hedge funds. Given the many types of strategies and the wide dispersion between top- and bottom-quartile performance, basing a view on average performance is questionable, and may lead investors to overlook some real potential benefits. Inevitably, though, these potential benefits involve tradeoffs. The most common is the sacrifice of liquidity most hedge fund investments require. Other drawbacks, depending upon the strategy, may be volatility (typically lower than equities, but still higher than some other strategies) and correlation with equities. Some healthcare entities are especially sensitive to these issues and also place a lower priority on the higher returns many hedge funds target. Nevertheless, they seek an absolute return strategy that may mitigate downside risks in a portfolio. Particularly for a hospital s defined benefit assets, which may be closed and embarking on a derisking journey, SIO can be an option for absolute return assets. As these plans move along a funded-ratio glide path, they seek to reduce the volatility of their funded ratios, primarily by increasing the duration of their hedging assets and diversifying the assets in their growth portfolios. For the latter task, two key considerations come into play. First, because of regulations and tax law, there are few rewards for overshooting the desired funding status the incentives are skewed toward protection on the downside. Second, these funds need to be able to dynamically adjust allocations, so liquidity matters. The SIO Composite vs. HFRI Weighted Composite Index chart examines the Strategic Income Opportunities composite in this light, comparing its return, volatility, beta and correlations since 2010 with those of the HFRI Weighted Composite Index. As the data show, the unconstrained strategy s profile in all these dimensions, together with its liquidity and cost-efficiency, make it a tool worth considering for healthcare pension plans seeking to secure some of the gains they have achieved along their glide paths. None of this is to argue that unconstrained fixed income is a cure-all, or the only option available to a healthcare system with the objectives discussed here. Investing always involves tradeoffs. In the case of the pension plan, one result of diversifying with an absolute return strategy would be to narrow the scope for possible beta returns from equities or other asset classes. The point is simply that in investing as in many other endeavors, adversity often gives rise to innovation. When more traditional asset classes and strategies no longer fully serve a desired purpose, it makes sense to consider something different. And unconstrained fixed income s characteristics make it worth considering for a variety of purposes we commonly see in healthcare portfolios. 4

5 HISTORICAL DATA BLACKROCK STRATEGIC INCOME OPPORTUNITIES COMPOSITE Calendar year Gross of fee composite return (%) Net of fee composite return (%) Benchmark return (%) Number of portfolios Composite dispersion (%) Composite 3yr Annualized Standard Deviation (%)* Benchmark 3yr Annualized Standard Deviation (%)* Total assets at end of period (USD millions) 1/4 31/12/ NM N/A N/A 1,433 < NM N/A N/A 2,783 < NM N/A N/A 3,717 < NM ,237 < NM ,135 < NM ,893 < NM ,891 <1 1/1 9/30/ NM ,447 <1 Past performance is not indicative of future results. Please see below for important disclosures related to this composite. Data shown may be subject to revisions from time to time based on availability of new information. Any such revisions are not material. *N/A 36 months of data is not available for that period. Percentage of firm assets Notes: 1. For purposes of compliance with the Global Investment Performance Standards (GIPS ), the firm refers to the investment adviser and national trust bank subsidiaries of BlackRock, Inc., located globally. This definition excludes: i) BlackRock subsidiaries that do not provide investment advisory or management services, ii) the Absolute Return Strategies (fundsofhedge-funds) business unit under the BlackRock Alternative Advisers platform, iii) BlackRock Capital Investment Corporation, LLC, and iv) FutureAdvisor, Inc. 2. BlackRock claims compliance with the GIPS standards and has prepared and presented this report in compliance with the GIPS standards. BlackRock has been independently verified for the periods 1 January 1993 through 31 December The verification reports are available upon request. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm s policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Verification does not ensure the accuracy of any specific composite presentation. The firm is verified annually by Deloitte & Touche LLP. 3. BlackRock uses a time-weighted linked rate of return formula with adjustments for cash flows to calculate rates of return. Trade date accounting has been used since the inception of the composite. The currency used to calculate performance is US dollars. 4. The benchmark index shown is the BofA ML 3 Month Treasury Bill Index. 5. Composite dispersion measures represent the consistency of a firm s composite performance results with respect to the individual portfolio returns within a composite. Dispersion is represented by the asset-weighted standard deviation of only portfolios that have been included in the composite style for a full year. For composites containing only one account, a measure of dispersion is not meaningful (NM). Dispersion presented for the periods from inception through 31 December 2014 has changed due to a change in calculation methodology. Prior to 1 June 2015 dispersion was calculated as the square root of the sum of monthly variances of portfolio returns around the composite returns. The monthly variance is the sum of the asset-weighted squared differences between the individual portfolio returns and the composite returns. Only portfolios that were included in the composite style for a full month were accounted for in the dispersion calculation. 6. Percentage of Firm Assets are rounded to the nearest whole percent. 7. There have been no alterations of the composite due to changes in personnel or other reasons. 8. When permitted by investment guidelines, leverage may be used in the portfolio, but is not integral to the investment process. The use of derivatives and shorting are integral to the investment process for the portfolios in this composite, there are no constraints regarding derivative usage and no range is to be provided as it will vary at the discretion of PMG and market conditions. Derivatives include options, futures, total return swaps, foreign currency transactions, and TBA s. The fund uses derivatives as a substitute for taking a position in the underlying asset and/or as part of a strategy designed to reduce exposure to other risks, such as currency risk. The strategy may seek to obtain market exposure to the securities in which it primarily invests by buying/selling contracts or by using other investment techniques. 9. Gross of fee performance results are presented before management and custodial fees and net of broker fees, transaction costs, and withholding taxes (If applicable). Certain portfolios may have custodial fees included. As of 1 April 2014, net performance reflects the deduction of the highest management fee per the strategy fee schedule. Prior to this date, net performance reflected the deduction of the highest management fee that could have been charged to any account in the composite. The management fee schedule for this strategy for institutional separate accounts in excess of $1 billion is a flat fee of 0.55 of 1% on all assets. 10. A complete list and description of all composites maintained by BlackRock and the related performance results are available upon request. Additional information regarding policies for calculating and reporting returns as well as valuation policies is also available upon request. The BlackRock Strategic Income Opportunities Composite is comprised of all fully discretionary, unconstrained total return fixed income portfolios that has the flexibility to invest across all fixed income asset classes and manage duration within a risk controlled framework. These portfolios have at least $50 million in assets and are not actively managed to a specific benchmark. The BofA ML 3 Month Treasury Bill index is used for performance comparisons only. All accounts included in the composite follow a similar investment philosophy. The creation date of the composite is 11 February The composite does not have a Significant Cash Flow Policy. 5

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