Hunting For Yield

HOOPP has announced their adoption of LDI 2.0 and today we will analyze precisely what has changed from their current LDI strategy. I have previously discussed the overall investment strategy of HOOPP here: HOOPP Investment Strategy Explained.

Current Environment

Low rate environment

The environment that we are currently in has some challenging times ahead. The Bank of Canada benchmark interest rate remains at 0.25% as of September 7, 2021. The next update will be coming out shortly on October 26 but expectations are for the rate to remain at 0.25%. In addition to this, CPI rose 4.4% on a year-over-year basis in September, the highest inflation since February 2003.

With inflation running higher, you would think the central banks would be quick to increase their benchmark interest rates. However, it is rarely that simple. With governments running extremely large budgetary deficits and current debt-to-GDP ratios, their central banks need to keep all borrowing rates or costs as low as possible for as long as possible. There really is no way that the Fed and the Bank of Canada can lift from zero lower bound and taper off QE anytime soon.

This will bring some stability out to intermediate maturity bond yields but some investors will be required to take on more term risk out of the yield curve in the face of increasing supply and reflationary price measures while others will also have to look at adding riskier debt securities. Long term investors will have to allocate more of their total portfolios to other traditional and less traditional return seeking asset classes, both liquid and less liquid. The current environment gives investors little choice other than to take on and manage more risk.

Deflationary risk not a base case

Besides the inflation question that the masses are wondering about, there is also the deflationary camp. While HOOPP believes deflation is a risk, it’s not the plan’s base scenario. HOOPP’s base scenario is that we’re in a low inflation and low interest rate period for a number of years and then we may get inflation at some point after that.

However, HOOPP also recognizes the real risk of deflation and is the reason they don’t want a zero nominal bond portfolio weighting. They remain to have a significant exposure to nominal bonds and that would help the plan in a deflationary scenario. Nominal bonds also provide very important liquidity purposes for the plan.

Adoption of LDI 2.0

Reduction in Fixed Income assets

The biggest change in LDI 2.0 is the reduction in Fixed Income assets as interest rates have declined sharply. HOOPP believes that fixed income assets will provide minimal returns going forward. When yields get this low they are not as effective as a hedge. They also will never invest in negative yielding bonds. Even in the scenario where you can make a lot of money if bond yield go more negative, it’s not a strategy they are interested in participating in as its very risky.

An important note is that the selling of bonds wasn’t part of a big tactical call on inflation. But rather a required return call as yield on long bonds fell near zero.

Introduction of Infrastructure

One major change that HOOPP is introducing with the reduction in Fixed Income assets, is the introduction of a new asset class – Infrastructure. Compared to other large Canadian pension plans, HOOPP is late adding Infrastructure to their Plan. However, it is interesting to note that alternative investments continue to be sought after as yields on fixed income continue to decrease.

As the Infrastructure investments are at least partially done in-house, it will take sometime for their allocations to ramp up. HOOPP believes that infrastructure serves a number of purposes, including replacement of returns out of the fixed income assets and hedging purposes, whether it’s to inflation or to a decline in rates.

Other allocation adjustments

There are a bunch of other adjustments that HOOPP is making in relation to the new LDI 2.0 strategy, including:

• Launched an insurance-linked securities program
• Increased allocation to un-correlated assets such as absolute return strategies (via external managers)
• Higher focus on international diversification
• Increased allocation to equities
• Within fixed income, increased allocation to Canadian provincial bonds and international exposure to find higher yields
• Taking more concentrated positions in higher yielding equities and bonds
  • Traditionally, they have invested synthetically in the S&P 500 and the S&P/TSX. However, they will now be adding to their holding of high yielding securities when opportunities arise. That’s what they did with Canadian banks and provincial bonds.

See below for a table of the current long-term policy asset mix for HOOPP:

Canada is home to some of the best performing pension funds and at the top of that list is HOOPP. Today we take a deeper look into HOOPP’s investment strategy.

Risks

At the heart of HOOPP’s investment strategy is the risk that it faces. The biggest risk is that the fund must make its payments for its members in retirement. There are three main risks that would affect the ability to do so:

1. Equity market risk,
2. Decline in long-term interest rates, and
3. Unexpected rise in inflation

Equity market risk represents the risk that at any point in time, equities can go down quite a lot as was the case during the global financial crisis in 2008. A decline in long-term interest rates makes it more difficult to invest contributions that are received over the life of the plan due to smaller investment returns. Lastly, while an unexpected rise in inflation is beneficial to plan members as wages rise, the pension plan needs to pay out more in benefits and hence needs to be able to fund for this.

The best way to manage these risks are to own assets that have the same characteristics as the liabilities (future pension payments). Said another way, own assets that exhibit less sensitive to equities, appreciate when interest rates are declining and appreciate when inflation is increasing. These characteristics are at the cornerstone of HOOPP’s investment strategy, specifically the liability driven investing strategy that HOOPP utilizes.

Portfolio Overview

HOOPP manages its total portfolio with two smaller portfolios:

1. Liability hedge portfolio
2. Return seeking portfolio

Within the liability hedge portfolio, HOOPP owns long-term bonds, real return bonds, real estate, short-term and cash. These assets are all linked to the liabilities of the plan:

• long-term bonds will appreciate as interest rates decrease
• real return bonds and real estate both have inflation sensitive characteristics that will offset increasing inflation

If the return received from the liability hedge portfolio would be enough to fund the pension liabilities going forward, they would have their whole portfolio just be this portfolio. However, this is not the case and instead they have another portfolio called return seeking portfolio whose purpose is to generate higher returns for the plan. The return seeking portfolio includes the following to achieve this goal: public equity exposure including through derivatives, corporate credit exposure also including through derivatives, private equity, hybrid strategies and more recently added infrastructure.

The long-term policy asset mix as found in their SIP&P effective January 21, 2021 is as:

Asset Class Strategy

Foreign Exchange

All of HOOPP’s investments are currency hedged, ensuring that HOOPP’s foreign investments are protected against changes in currency prices.

Fixed Income

The fixed income portion includes bonds as mid-term, long-term, inflation-linked bonds and real return bonds. The purpose of the asset class is to generate a steady stream of income to help pay current and future pension payments. The investment in various bonds mitigates interest rate risk of pension liabilities. The investment in real return bonds mitigates inflation risk.

Real Estate

The income and cash flow generated by real estate properties have a high degree of reliability and in times of inflation can act as a good hedge as rental values increase. From a strategy perspective, the plan aims to acquire and hold well located and well leased properties that have the potential to generate stable and predictable income streams. Diversified the portfolio by geography and asset type (ex. office, industrial, residential, etc.). Performance is augmented through development of new properties. In this way, any created value from development remains with the Fund and its members.

Public Equity

Companies are chosen based on strong strong fundamentals and purchased at a price below their intrinsic value. They determine this by utilizing discounted cash flow analysis modelling. In addition, they pay attention to balance sheet strength, return on capital, level and stability of margins, free cash flow generation and management strength. They engage with management if needed in regards to ESG issues. They are diversified geographically with a bias towards medium to large cap stocks.

Private Equity

Makes investments in all types of capital with the exception of senior debt. Investments are made directly and indirectly through private equity funds. They invest globally with a bias towards developed economies.

Hybrid Strategies

Hybrid strategies includes investments such as credit and absolute return strategies. Designed to earn positive returns with minimal or without sensitivities to interest rates, credit or equities.

Infrastructure

Infrastructure is the most recent addition by HOOPP as part of their new LDI 2.0 strategy. They are targeting to invest in high-value and long-duration investments in sectors such as communications and data, power generation and transmission, energy, transportation and utilities. The fund invests both directly and indirectly through external managers.

Derivatives

Derivatives play a crucial role in management of the fund – to both juice returns and hedge risks. As an example of this:

If you sell a bond and buy a stock, that’s a level of risk. If you instead use an underlying bond asset to have exposure to a stock, it’s a less risky way of equity exposure than direct exposure.

When derivatives are used instead of direct ownership for stocks, the money that would have been used to buy securities is instead invested in short-term government and investment grade corporate bonds. HOOPP’s investment in these bonds support various derivative-based strategies and generate additional returns for the Plan by taking advantage of opportunities in foreign and domestic bond markets.

LDI 2.0

HOOPP has announced changes to their pension plan that reflect todays market environment. I go over the environment and HOOPP’s changes here: HOOPP Adopts LDI 2.0