February 15, 2020 | Institutional Perspectives | 6 min read
Ballast in the Storm: In Defense of Bonds in a Decade of Low Interest Rates
The 2010s were capped off by a strong 2019 in which the majority of asset classes globally enjoyed significant gains.
In Canada, the FTSE Canada Universe Bond Index rose 6.9 percent last year, the third-best year of the decade and one which handily beat the 4.3 percent 10-year annualized rate of return. Strong bond returns were generated under a backdrop of falling interest rates where nominal 10-year bond yields in Canada fell from 3.6 percent to 1.7 percent over 10 years. The 10-year real interest rate, which excludes inflation, was 1.5 percent a decade ago and is currently now near zero.
While falling interest rates benefit bonds by generating positive capital gains in the short term, ever-decreasing yields have muted expected returns moving forward. With the yield of the FTSE Canada Universe Bond Index currently at 2.3 percent, interest rates will have to fall even further in order to reach returns experienced in the prior decade.
While recognizing that the low yield of bonds increases the risk that pension and endowment plans do not meet their investment objectives, we continue to believe in their strategic importance as an excellent stabilizer and capital preserver within efficiently optimized portfolios.
Common Theme
A common theme over the past 10 years has been the downward adjustment of return expectations for asset-liability models. According to the National Association of State Retirement Administrators, the median rate of assumed returns for U.S.-based public pension plans has fallen to 7.3 percent from 7.5 percent in 2015 and eight percent in 20101. In Canada, there have been examples of some public pension plans now using nominal return targets closer to five percent to 5.5 percent, down from seven percent to 7.5 percent in 20002. Endowments, on the other hand, have in some cases cut back spending targets to three percent to 3.5 percent from four percent to 4.5 percent a decade ago.
With the reduction of return expectations, many plans have shifted their asset composition to seek higher returns. This has led to the proliferation of investments in emerging markets and high-yield debt, small/mid-cap equities and illiquid assets such private equity and debt, mortgages, and infrastructure. However, the trade-off for a higher rate of return is always a higher level of risk, whether it be credit risk, foreign investment risk, or liquidity risk.
Over the past 20 years, government bonds have displayed negative correlations with equities and investors have relied on this relationship to lean on their bond portfolio as their ‘ballast,’ especially during periods of extreme market stress like the Great Financial Crisis, when the correlation between many risk assets tended toward one. During this time, it was investment grade and government bonds that served as the sole shock absorber. With the introduction of new, higher-risk asset classes to portfolios, we believe more than ever in the importance of this relationship. The inclusion of high-quality bonds in any portfolio, held to maturity, can offer capital protection. Assuming higher-risk assets return six percent to eight percent and bonds return two percent to 2.5 percent, we believe that fixed income, with its merits as a capital preserver and source of liquidity, still needs to play an important role in new and evolving asset mixes.
"A common theme over the past 10 years has been the downward adjustment of return expectations for asset-liability models. According to the National Association of State Retirement Administrators, the median rate of assumed returns for U.S.-based public pension plans has fallen to 7.3 percent from 7.5 percent in 2015 and eight percent in 20101."
What If Rates Rise?
With interest rates at multi-decade lows, it is fair to ask whether rates could or should eventually rise, leading to the potential for negative bond returns. While a gradual shift away from central bank-led monetary policy towards fiscal spending by governments may finally stimulate economic growth and drive higher interest rates, we believe that there are also fundamental factors that could keep interest rates low for longer.
Globally, due to the aging population of many developed market countries, the potential for future growth as well as inflation is subdued. Moreover, baby boomers have spent the past 50 years creating and accumulating wealth and then benefiting from the last decade of rising markets. As many transition into retirement, their investments continue to shift out of higher-risk equities into lower-risk bonds, pushing the yield on risk-free government bonds down.
Quantitative easing has been and continues to be a primary monetary policy tactic where the central bank purchases long-dated governments bonds, thereby providing the market with cash and suppressing long-term interest rates, in order to stimulate economic activity. During a brief period of an improving global economic outlook between 2017 and 2019, the U.S. Federal Reserve sought to reduce quantitative easing. But by September 2019, the Fed had finished. Balance sheet assets were reduced to $3.8 trillion, down from $4.5 trillion at its peak but still much higher than the $700 billion prior to the Great Financial Crisis. With global growth concerns resurfacing once again, it may take a number of years before central banks choose to re-engage in the delicate task of winding down their quantitative easing programs.
Figure 1 - 700 Years of History: Real Rates
In a recently released working paper3, researchers at the Bank of England reconstructed global interest rate trends in regions covering 78 per cent of the world’s advanced economy GDP, dating back to the 14th century. The study found that real interest rates have not been stable across successive monetary and fiscal regimes but have seen a gradual decline since the late Middle Ages, with periods of temporary reversal (see Figure 1). So history also tells us that zero real interest rates could possibly be the norm going forward.
Pension Plan Impact
For pension plans, the discount rate, typically derived from either government or corporate bond yields, impacts present values for both plan assets and liabilities. Much like assets, pension liabilities have an inverse relationship with interest rates: lower rates drive larger values. However, on the liability side, it’s the present value of what a pension plan owes to its members. While the easing of post-solvency requirements in a number of jurisdictions over recent years has somewhat reduced the sensitivity of pension liabilities to interest rates, the importance of bonds, particularly long-dated bonds, remains.
Liability-driven strategies have long recognized the benefit of hedging plan liability exposure to rates by matching off the ‘dollar duration’ of the portfolio meant to fund those liabilities. A long duration of liabilities is matched with a long duration of bonds held in the portfolio. As plans confront the challenges wrought by the very low interest rate environment and restructure their portfolios away from long bonds into risk assets like public equities and infrastructure, or shorten their duration to plumb the high yield market in response, they would do well to remember the risk of mismatched duration.
If interest rates were to decline further, actuarial discount rates would inevitably follow. In such a scenario, as pension liabilities rise, the value of bonds held within the portfolio would increase as well but at a rate commensurate with its duration. In a further-falling rate environment, this hedge would underperform materially if the portfolio had reduced its sensitivity to that change in interest rates.
Given this relationship to pension liabilities, its low correlation to equities and other risk seeking assets, and the liquidity its reliable stream of cash flows provides for funding pension obligations, it is our view that fixed income should continue to play an important role in pension portfolios.
Note this article first appeared in the March 2020 edition of Benefits & Pensions Monitor. Republished with permission.
1Source: https://www.nasra.org/files/Is... percent20Briefs/NASRAInvReturnAssumptBrief.pdf
2Sources: Public Service Pension Plan 2017 Annual Report, Fraser Institute (references Ontario Teachers Pension Plan).
3Source: Paul Schmelzing, Bank of England. https://www.bankofengland.co.u...
IMPORTANT NOTE: This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided is compiled from our own research that we believe to be reasonable and accurate at the time of writing, but is subject to change without notice. Forward looking statements are based on our assumptions, results could differ materially.
Reg. T.M., M.K. Leith Wheeler Investment Counsel Ltd.
M.D., M.K. Leith Wheeler Investment Counsel Ltd.
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