By Joel Kranc
Following the Great Recession of 2008 along with the financial crisis that rocked real estate, credit and equity markets; interest rates remained historically low, and for a long time hovered around the zero percentage mark. But following the COVID pandemic, and the resilience of a tight labor market, inflation started to climb in 2022, leading to central banks around the world to increase rates.
During those low-interest-rate periods, the Bank of Canada found that 64% of pension plans shifted away from the traditional 60/40 equity to fixed income allocation. So where are investors today when it comes to the fixed income portion of their portfolios?
Sebastian Betermier, executive director of the International Centre for Pension Management and associate professor of Finance at McGill University, says a few things have occurred as a result of interest rate hikes.
The first, he notes is that a drastic increase in yields over a short period of time has been both good and bad. “On the one hand, if you own bonds, that’s not great because those bonds have lost value,” he says. “On the other hand, if you want to purchase new bonds, you’re getting them at much higher rates than you used to.”
Most importantly, adds Betermier, depending on the fund itself (i.e. those that are regulated more on a solvency basis), “In general, when you evaluate the liabilities of the funds, and the liabilities of the funds look like bonds, those liabilities have fallen a lot in value. So even though bond yields have increased and asset values in the portfolio have decreased, for many funds the funding ratio has gone up because the liability portfolio has fallen more so than the assets.”
Mazen Shakeel, partner and practice leader with TELUS Health, agrees, adding, “There is a bit of a levered effect where the impact of rising rates on liabilities for a lot of plans was greater than the impact on assets so liabilities fell more than assets fell. And over the course of 2022, the funded position of a pension plan, on a solvency or wind-up basis, improved by almost four percent. Through the first quarter of 2023 the funded position of plans improved even further, roughly one or two percent.”
Where will inflation take us next?
There’s no reason to assume rates are going back to zero anytime soon. Inflation is coming down but certainly still high for many sectors like groceries, for example. “Fixed income is better than it’s been in a decade and we’re seeing a lot of funds go into the asset class,” says JC O’Connell, Director & Associate Portfolio Manager at Davis-Rea Ltd. Investment Counsel. “Provided rates don’t go back to zero, it’s probably a trend we’ll see for some time.”
He further adds, “When you’re coming to the end of the cycle and there may be a recession that would be negative for stocks, taking out the two-year Treasury — a risk-free bond and locking that in at four percent for two years — that’s pretty attractive to me.”
Currently, many pension funds are either fully funded or nearly fully funded. Shakeel says everyone is watching the volatility of the markets and wants to protect themselves on the downside if rates start to come down. “We don’t know if we are near peak bond yields or peak interest rates yet, but we know we are closer to the peak than we have been over the last year and a quarter. We’re not able to time any reversal of interest rates or bond yields with any level of precision but the downside of falling rates and falling yields is greater than the upside of rates going up a little bit more.”
That’s why the current conversation is about mitigating or de-risking interest rate risk by either investing in bonds or lengthening the duration of the bond portfolio.
Betermier says that over time, bonds are not a great hedge against inflation. “What that means is you will see alternative forms of inflation hedging like infrastructure or real estate, that have bond-like properties. If I invest in a bridge or toll-highway and money is coming in every year, it looks very much like the cash flows of a bond,” he adds.
The phenomenon of investing in alterative assets is more for larger pension funds or funds with longer time horizons, mainly because they are less liquid, explains Shakeel. “Larger plans have more flexibility, and once there is certainty with interest rates, there may be opportunities to take on more risk because there isn’t a short-term time horizon that will lock you into one strategy or another.”
