Liability Driven Investing (LDI) in Canada: A distinct approach Rachna de Koning, FCIA, FSA, Vice President & Director Michael Augustine, CFA, FCIA, FSA, Vice President & Director TD Asset Management
A question of risk Are LDI and de-risking becoming synonymous? 2
The unique Canadian LDI landscape Success comes from smart and pragmatic implementation Unique actuarial standards Supply and demand: size and composition 3
LDI benchmark challenges Discount rates: insufficient tools Subjective and theoretical No market for liabilities 4
Another challenge: Multiple measures Solvency funding and accounting Two different measures, based on different methodologies, that do not move in tandem. To the extent you veer in one direction, you introduce risk in another and that risk needs to be budgeted for 5
More to LDI than just extending duration Assumption: Liability cash flows of duration 16.7 years, valued on an economic basis (government of Canada curve) at December 31, 2013. Source: Canadian Institute of Actuaries, TDAM Portfolio Analytics 6
Credit spread driver is significant Credit is 30% of discount rate Credit is 16% of discount rate Assumption: Liability cash flows of duration 16.7 years, valued on an economic basis (government of Canada curve) at December 31, 2013. Source: PC-Bond Analytics, TDAM Portfolio Analytics. 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. Your LDI benchmark includes a proxy credit component Credit weight persists in a lower-for-longer environment 7
How many times do you think actuarial standards, guidance and educational notes have changed in the last 5 years? 1. Less than 5 2. 5-15 3. 15-25 4. 25-35 Source: Canadian Institute of Actuaries 8
Adjust LDI strategy to fit changing guidance Liabilities change along the way: New membership data Market realities lead to new guidance Better models Mortality table change: Good news Canadians are living longer 9
An imprecise combination of art and science LDI benchmark: Precision is a fallacy Removing all risks is impossible 10
Canadian fixed income landscape LDI benchmarks are fixed income based Unique supply characteristics Market segmentation and demand 11
Is fifty the new thirty? On May 16, 2014 5 year Canadian bond yields were 1.55% 10 year Canadian bond yields were 2.26% 30 year Canadian bond yields were 2.81% How much did a 50 year Canadian bond yield? 1. 2.75% 2. 2.80% 3. 2.91% 4. 3.09% Source: Bloomberg Finance L.P. 12
Federal government bond market Average term to maturity Canada Budget Source: Public Accounts of Canada: Department of Finance Term of debt is increasing Currently Canada's federal bonds are 40% of Universe and 25% of Long Universe but improving fiscal position is projected to decrease bond supply 13
In Canada, what is a donut? 1. Sugary treat found at your local Tim Horton s 2. A perpetual bond issued by the provinces 3. Innovative debt structure issued by provinces to meet unique Canadian market needs 4. A floating rate provincial bond reset quarterly 14
Provincial government bond market Provincial strip bond market Retail Investors Life Insurers / Pension Funds 10 years 25 years Moderate liquidity Extremely illiquid Most liquid Provincial government bonds are uniquely Canadian: 30% of Universe, 50% of Long Universe, and primary issuer of ultra-long bonds; Long duration used for innovative Asset Liability Management/LDI solutions 15
How many long AA-rated corporate bonds are there in Canada? 1. 126 2. 49 3. 14 4. 5 As per S&P ratings 16
Long corporate bond market Long Corporate Bond Issuance 2013 Long Corporate Bond Universe (by credit rating) Long Corporate Bond Universe (by industry) AA 3% BBB 33% A 64% Infrastructure 42% Energy 26% As of December 31, 2013. Source: TD Securities Inc. As of December 31, 2013. Source: PC-Bond Analytics. 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. Record high water mark of new bond issuance in 2013 25% of Long Universe; but limited high quality long corporate bonds 17
Market segmentation affects valuation 160 Corporate and provincial bond spreads Credit Spread (bps) 120 80 40 Province of Ontario Bond Corporate Issuer 0 0 5 10 15 20 25 30 35 40 45 50 Term to Maturity As of December 31, 2013. Source: PC-Bond Analytics 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. Double Coincidence of Needs: Pension Funds and Financial Stability Bank of Canada, speech, May 2014 Investor term preference can affect relative value in the marketplace 18
A holistic view of LDI in Canada Must be smart and pragmatic Use balance and flexibility Move beyond the basics Widen the opportunity set Be active 19
Be balanced Set objectives and budget for risk Allow for trade-offs Consider all asset classes Bonds; domestic and global Equities Real estate Infrastructure 20
Move beyond the basics What does your LDI benchmark require? Basis Credit as % of discount rate Credit Spread (bps) Liability ($mm) Economic 0 0 100 Solvency (AP) 16% 58 91 Solvency (LS) 16% 61 90 Accounting 30% 134 81 What can the market give you? Bond Portfolio Credit Spread (bps) Assets Required ($mm) Long Canada Bonds 0 100 Long Bond Universe 82 88 Long Corporate A 152 80 Long Corporate BBB 199 75 LDI 2.0 recognizes the value of corporate bonds In low interest rate environment credit is more important For illustrative purposes only. 21
Think beyond AA-rated bonds Bond Portfolio Long AA Corporate Bonds Correlation to Accounting Liability High by definition Long A Corporate Bonds 94% Long BBB Corporate Bonds 88% Bond returns can be highly correlated Be flexible and diversify using entire universe Must be thoughtful about credit markets 22
Widen the opportunity set Most portfolios are only 40% to 60% bonds Bond overlays can increase the liability duration match and can also provide a good source of additional income Equities, real estate and infrastructure can increase the liability inflation and credit match and can also provide a good source of income 23
Actively manage your risk As fixed income becomes a larger part of the asset mix, consider active management, taking advantage of: Independent credit research Industry diversification Yield and credit curve analysis Security selection 24
LDI in Canada: Opportunities abound Turn challenges into opportunities through smart thinking and pragmatic implementation 25
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