Q. Interest rates remain at historic lows – what are some strategies for optimizing our fixed income asset allocation

If low rates are the new normal, what’s needed to optimize a fixed income portfolio is really a change in the mindset of investors. Historically, you could simply invest in public market bond funds and earn an adequate return. With rates so low, investors are looking to fixed income alternatives, such as high yield, private debt, infrastructure investments, real estate, and commercial mortgages.  

For private market investments, the change in mindset involves embracing a trade off – expected steady, predictable higher yields in exchange for less liquidity. The higher yields reflect the fact that private investments are carefully negotiated and highly customized to meet the needs of both parties (a customization premium). The higher yields also compensate for the lack of a secondary market for the investment (an illiquidity premium). 

We know from talking to pension plan sponsors across the country of their need to enhance their fixed income returns.  Many plans are experiencing a funding gap and need higher returns to help bridge that gap. At the same time, given their long-term time horizon and the fact that on-going payments in their plans are fairly certain, most pension plans and endowments realize that they have more liquidity than they need to cover their ongoing liabilities. The “low hanging fruit” opportunity is the trade off between yield –  which they don’t have enough of – and liquidity – where they have an excess – to enhance portfolio returns.

What investing in private markets does require is great care in choosing your manager. Private fixed income investing requires a highly-specialized skill set and level of expertise. Ideally, you’re looking for a manager with strong origination capabilities, meaning a broad and sustainable investment pipeline, a clearly articulated investment philosophy and process, and strong governance that aligns the interest of the manager and investor. A lot of money has poured into this sector in the last five years. So you also want a manager that’s proven itself – one that has seen the ups and downs of the credit cycle and also one with the high organizational strength, business diversification, and longevity that aligns with your investment time horizon.

Every investor is different, and the specific optimization of a fixed income asset allocation for a pension plan requires a more precise look at plan liabilities. That said, in our view most plans can benefit from the increased diversification and higher yields that alternative fixed income investments can provide.

Eugene Lundrigan is President of SLC Management Canada, a Sun Life business that offers investment solutions to defined benefits pension plan clients and other institutional investors.