canadian fixed income

June 2006

Beyond Vanilla Fixed Income

“From Boring Diversifier to Alpha Source”

Jamie ColliverFixed Income Seminar

CAUBO June 2009

June 2006

Fixed Income in Canada

Early Rationale for Bond Allocations: Vanilla Ice Cream!

• Core holding to provide stable returns…flight to quality syndrome, Board/Trustee “feel good, sleep at night”

• Willing to live with lower returns because equities will outperform…always count on double digit equity returns

• Index holdings then forget about it…actually be paid to index so your bonds could be leveraged

• Willing to live with the duration mismatch of liabilities…RRB’s have helped

• Liabilities in Canada…should own $ C bonds…home bias, we understand domestic bonds even if we don’t understand our liabilities

• No currency exposure on any foreign bond holdings…fully hedged…any bond returns easily wiped out by currency swings

June 2006

Investment risk was measured as

volatility of returns,

or relative to benchmarks

not relative to liabilities

Asset mix typically

60% stocks 40% bonds

Not enough alpha.

Too much volatility.

Interest rates fell almost

continuously since the 1980’s

which increased PV of liabilities

Stock markets outperformed in

the 1990’s

then did not meet assumed rates of return when the

bubble burst

while PV of liabilities grew

faster

Bond portfolios were short term, usually measured against a Universe

Bond Index,

so as rates rose, value of bond

portfolios did not rise as much as PV of liabilities grew

Implications for Pension Plans

June 2006


New Bond Reality : Vanilla Chocolate Chip!

• 40 - 50 % of total portfolio requires focus:

Return source Alpha source

• Must generate better returns, equities will not subsidize

• Foreign Property Rule removed...a “world” of opportunity

• Must move beyond domestic fixed income markets

• LDI - Liability matching and duration will drive asset allocation

• Alpha/Beta separation…bond beta cheap

June 2006


New Reality for Bonds

• More liability studies undertaken by consultants…liability consultants showing up now with new technology

• Plans/Boards/Trustees need education in the …...“ World of Fixed Income “….especially markets outside Canada

• More fixed income customization….replicating yield curves to match duration of assets…LDI

• More “packaged solutions” for the medium and smaller plans

• Plans in Canada are finally reviewing their fixed income allocations…looking to “ Core Plus “

June 2006

What About Bonds?

Universe courtesy of Mercer Investment Consulting. Calculations monthly in $CDN. Past performance is not indicative of future results.

Performance before fees for periods ended December 2008Rates of Return(%)

17

8

-1

-10

-19

1 Year (% ) 2 Years (% pa) 3 Years (% pa) 4 Years (% pa) 5 Years (% pa)

DEXU 6.4 5.0 4.7 5.1 5.5

Range of 2.8% between top and bottom performers

Limited Fixed I ncome Opportunities in CanadaCanada represents only 3% of the world’s total fixed income market

June 2006

What About Bonds? Greater opportunities globally

Rates of Return(%)

Expanded Global Opportunities

Over 96% of Fixed Income Opportunities

Range of 7.9% between top and

bottom performers

Global Fixed Income Universe courtesy of Evestment. Calculations quarterly in $US.

Performance before fees for periods ended December 31, 2008

June 2006

The DB Dilemma

It’s real. It’s here!

Time to “ de risk “?


June 2006

2008 Pension Crisis – Numbers tell everything

• Solvency Deficiencies

– Funded ratios dropped from 96% to 69 %

• 88 % of Canadian executives say we have a crisis (1)

• 10 % of companies consider their pension plans as a “ threat to their survival “(2)

• Corporate earnings down significantly

• DB assets down 18 %

• DC returns typically lag DB by 2 % with members assuming investment risk

• Pension plans must assume risk to secure the pension promise

(1)2009 Watson Wyatt/Conference Board Survey

(2)SEI


June 2006

DB Dilemma in Canada

• Plans must reduce liability exposure to DB plans – Solution: DB plans are closing or frozen

• Financial statements of sponsors more exposed to pension risks

• Mark to market impact immediate to DB plans with poor performance – should be non-correlated to income statements

• Sponsors must seek conservative approaches with investment policies and asset allocation

• Higher allocations to fixed income, long bonds in particular

• LDI > more swaps and derivatives for synthetic beta

• Removal of FPR has led to “ Core – Plus “ mandates adding value using HY or EM - more volatility


June 2006

To De-Risk or Not?

• Corporations cutting benefits and increasing contributions forcing them to consider a de-risking approach even if only extending bond duration

• Liability matching with bonds or other assets

• Over 80 % of Plans have say they will not exceed 60 %bonds(1)

• Real Estate or Infrastructure top list for risk minimization and stabilizing returns

• Other assets include interest rate swaps/overlays, hedge funds, repos, private debt, RRB’s, and dividend yielding equities

• Likely make changes within a year or two(1)

(1) Benefits Canada


June 2006

LDI is coming….

• Viewing portfolio construction through an “LDI lens” is a valuable process even if asset allocation is ultimately not changed.

• No “one-size-fits-all” LDI solution exists.

• Expect more diversity in asset strategy as plan sponsors incorporate unique circumstances, seek further diversification and embrace asset classes/strategies that offer high potential for active management.

• For corporate plans, expect a gradual migration from intermediate duration to longer duration and increase in fixed income allocations

• Envision derivative-based solutions to be more widely accepted as a standard tool to hedge liabilities and port alpha

• Smaller plans and those seeking simplicity will migrate, at least initially, towards pooled funds

• LDI affects all steps in the fiduciary process: assessing the existing position, strategic planning, implementation, and performance measurement

The Case for Liability Driven Investing

June 2006

-Stabilization of spreads starting but likely too early to declare a bottom

-Performance driven by liquidity not credit

-Liquidity improves just as fundamental economic data deteriorates

-Phenomenal opportunities exist right now from risk-adjusted returns available from bonds

Sector Spreads

June 2006

– Plans need to add risk to their portfolios as they re-balance and bonds are now viewed as alpha sources

– LDI emphasizes long term bonds and need for alpha and diversification

– Globalization of Canadian fixed income portfolios is evolving, but hurdles remain significant for some plans

– Effective global bond strategies vs. Canadian liabilities and benchmarks require careful risk management

– Returns from high quality fixed income are now possible given current sector spreads

Where do we go now? Ice Cream: no calories

canadian fixed income

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