Pension Funds: Go Long with Bonds

After a strong environment for most pension funds since the depths of the COVID crisis in March 2020, a potential storm may be brewing. In our view, restrictive monetary policy to tame inflation has increased the probability of a recession in 2023. An economic slowdown has been widely telegraphed and we think long bonds offer a bright spot amongst dark clouds for plan sponsors.

Despite the market turmoil in 2022, the S&P TSX Index is still up over 55 per cent since March 2020, meanwhile the 10-year Government of Canada bond yield has risen nearly 260 basis points in this period. We believe this combination has helped contribute to a significant improvement in pension funding levels ‒ a positive development for long-term fixed income strategies.

In this article, we discuss why we believe that pension funds may consider de-risking via long bonds and outline various approaches to transitioning to lower-risk pension fund strategies.

Why de-risk now?

For one, we believe if Canadian pension funds de-risk as their funded status improves, then a supply/demand imbalance for long bonds could develop. Per the Pension Investment Association of Canada (PIAC), as of December 31, 2021, the market value of total defined benefit pension plan assets topped $2.7 trillion, while the market value of the FTSE Long Term Bond Index is only $667 billion. While the demand for long bonds may keep long bond yields low, the lack of supply may prevent pension funds from being able to buy as many long bonds as needed. In other words, we consider the pension funds that are early adopters of long bond fixed income strategies may have an advantage. A similar imbalance has existed in the UK pension market, where pension funds began de-risking in the late 1990 in response to changes in UK pension regulations.

Secondly, we view that de-risking can help protect gains in funded status. Decades-high inflation led to a significant tightening of monetary policy in 2022, which negatively impacted almost all financial markets. Yet a silver lining amongst this market volatility is the health of Canadian DB pension plans. According to the ‘Mercer Pension Health Pulse,’ a measure that tracks the solvency ratio of Canadian pension plans, the median solvency ratio was 108 per cent as of September 30, 2022, hovering near the all-time highs for the index.

Despite negative equity returns in 2022, pension funds have enjoyed above-average equity returns in recent years. But perhaps more significantly, we’ve seen a sharp rise in yields. Not only have government bond yields risen, but so too have corporate credit spreads. In our view, the combination of these two factors has resulted in a significant increase in the yield of the FTSE Canada Long Term Bond Index. The yield on the index rose by 187 basis points in 2022 to its highest level in nearly a decade. Most plans have benefitted from this rising yield environment, where liability values have declined to a much greater extent than the decline in asset portfolios, resulting in an increase in funded status.

So higher yields have resulted in improved solvency ratios and, by considering a long bond portfolio structured to closely match a pension plan’s liability profile, plan sponsors can ‘lock in’ the gains made in the plan’s funded status. This provides some relief if interest rates decline or equity markets deliver negative returns. A key risk for many pension funds is falling yields; another risk is a decline in equities. We believe the combination of the two is disadvantageous for plan sponsors and, as economic growth deteriorates, these risks have increased. As we approach a possible end to the Bank of Canada’s tightening cycle, and recession risks rising, the risk of falling yields is increasing. For plans that have benefited from an improved funding status, we’d  argue now is the time to consider allocating to long bonds. By going long, plans can secure recent solvency gains while protecting against the dual threat of falling yields and declining equities.

Although 10-year bond yields have declined from 2022 peaks, today’s level is still higher than at any other time since 2011. As the Bank of Canada continues to grapple with bringing down decades-high inflation, we believe pension funds may experience significant volatility. The era of easy monetary policy has been unwound and replaced with restrictive interest rates and quantitative tightening. Starting a process to build a long bond portfolio over time may be prudent and would be similar to the ‘dollar cost averaging’ approach that is often used to build an equity market portfolio.

De-Risking in a Volatile Environment

We believe there are three aspects of a portfolio that will need to be addressed when beginning the de-risking process – current contributions, current fixed income portfolios, and increasing allocation to fixed income:

Current Contributions ‒ Allocating all new contributions to long bonds allows pension committees to get comfortable with investing in long bonds. The draw- back to this approach is that only a small percentage of the total fund will be derisked.

Current fixed income portfolios ‒ For existing fixed income portfolios, there are four methods that may be used to transition the current fixed income portfolio to long bonds:

One-time switch into long bonds

Often referred to as liability driven investing, or LDI, it involves buying bonds that have a similar duration to pension liabilities, which reduces exposure to changing interest rates. We believe this approach has the advantage of assets being de-risked quickly. In our view, the disadvantage is that it does not take into account the funded status of the plan and any further increases in interest rates would not benefit the funded status of the plan.

Time-based transition

This approach re-allocates the current fixed income portfolio into long bonds in equal increments over a pre-determined period of time. For example, 12.5 per cent of the fixed income portfolio would be transitioned into long bonds every quarter for the eight quarters of a two-year time period. We believe the advantage is that after a definite period of time, the portfolio would have moved into long bonds. In our view, the disadvantage is that this approach does not allow for a more rapid transition, nor does it take into account the funded status of the plan.

Yield-based transition

This approach re-allocates the current fixed income portfolio into long bonds gradually as yields rise. For example, a plan sponsor who believes that long bond yields will rise by two per cent in the future could move 12.5 per cent of the current fixed income portfolio for every 0.25 per cent increase in rates. In our view, the disadvantage is that if yields remain flat, there will be no transition into long bonds. This approach also does not take into account the funded status of the plan.

Time/yield-based transition

This approach combines time-based and yield-based approaches to ensure that the transition will occur if yields remain flat while also allowing the transition to occur more rapidly if yields increase. In our view, the disadvantage is that this approach does not take into account the effect that positive equity returns may have on the funded status.

Increasing allocation to fixed income ‒ Lastly, for plan sponsors looking to increase their allocation to fixed income, we believe they can use the same approaches described above, or they can use another method known as dynamic de-risking. This method adjusts the asset mix to a de-risked portfolio gradually as the funded status of the plan improves. Dynamic de-risking takes into account rising yields and excess equity returns. In our view, the disadvantage is that this approach requires the plan sponsor to monitor the plan on a regular basis ‒ daily, monthly, quarterly ‒ and for the investment committee to pre-determine the asset mix at various funding levels.

As we have discussed, a potential storm may be brewing for pension funds. We believe that rising recession risks in 2023 bring with it increasing probability of falling yields and declining equity values ‒ a poor combination for pension funds. Thankfully, the combination of favourable market dynamics and the significant improvement in funding levels may give plans a chance to revisit their risk tolerance. We believe that now is the time for pension funds to consider buying long bonds and working with an investment manager with the flexibility to implement one of the many approaches outlined.

Soami Kohly, CFA, FCIA is a Fixed Income Portfolio Manager and Investment Officer at MFS Investment Management. Michael Trudeau, CFA, is a Director and Investment Product Specialist at the firm.