Episode 52

Steve on LDI investing in the current environment

Steve Morris, Senior Managing Director & Portfolio Manager, Public Fixed Income at SLC Management, discusses shifts in LDI investing given rising interest rates in Canada.

Steve Peacher: Hi everybody, this is Steve Peacher, President of SLC Management and thank you for dialing in to this episode of “Three in Five.” And today I’m with Steve Morris, Steve is a managing director in our Canadian public fixed income area and he focuses particularly on the LDI portfolios that we manage for pension plans. LDI of course stands for ‘liability driven investing.’ Steve, thanks for taking a few minutes with us today.

Steve Morris: Well, thanks Steve, pleased to be here.

Steve Peacher: So, as I mentioned you manage portfolios for pension plans in Canada. Markets are always interesting they're particularly interesting today given the dramatic move in rates, inflation, geopolitical events, etc., As you talk to the clients you manage money for what are they thinking about?

Steve Morris: I meet with the plans across Canada and there's a lot going on at the moment, certainly agree that with the volatile markets and interest rates, inflation, and equity, these are top priorities for pension plans and how they're managing their overall positions. What I find is with interest rates having increased and long Canada bonds are around 3%, which is up substantially from around 167 at the beginning of the year,[1] the main factor a lot of plans are focused on is their improvement in their solvency levels. With these rates having increased pension plans are in a much better solvency position. What they're doing is they're looking at their asset mix positions and the complete array of asset mix choices. What they're looking at is taking the traditional liability driven approach and really expanding on that theme to looking at two components: the liability-oriented hedges and secondly, the return seeking components. It's a real evolution in terms of how to structure those two components within an asset mix strategy.

Steve Peacher: Well, as you mentioned an LDI portfolio generally has these two buckets, the liability hedge bucket, the return speaking bucket. And within each of those buckets there are choices that a pension fund can make in terms of their asset mix. So in today's environment you describe, especially with rates rising, which is a benefit for most pension plans. What decisions on the different types of asset classes that can be put in those buckets are clients and their consultants making for the portfolio?

Steve Morris: The pension plans are really evolving from that traditional 60/40 position years ago, 60 equity 40 fixed income, into these distinct buckets of the return seeking and the liability hedging. What I’m seeing with clients in the return seeking is really looking at equity futures. So they're taking traditional equity investments, replacing those with equity futures and then backing them with short term private fixed income. It’s a great technique, because what it's doing it's taking the beta coverage from the equity asset class and then the alpha comes from the floating rate, like futures. And the cash proceeds are invested in short term fixed income, which works really well. Another area pension plans are looking at is within inflation they're looking at real assets more and more, so they're investing more in infrastructure and real estate and these work extremely well long term. The other component is really looking at private fixed income. So, for the liability hedging component of their funds. Private fixed income, it's capturing a liquidity premium and really gives them better diversification, particularly in the Canadian market, with higher returns. And a recent popular asset class I’m seeing with clients is the growth of U.S. high yield fixed income assets. These assets hedge back to CAD also provide good diversification and higher yield. Then a final area of interest was for inflation linked liabilities. We're building a lot of real return bond portfolios across the term spectrum. So, inflation has really become a risk pension plans are aware of now in 2022 and clients are really focused on addressing this risk.

Steve Peacher: You know you mentioned equity futures, and of course futures are a form of derivative. Derivatives can be very useful in portfolio construction, but they can be scary to some investors, some professional investors that haven't used them. But as you mentioned, the strategy with equity futures and short duration and maybe becoming a bit more mainstream. Are you finding that your pension clients are more interested in derivatives and the kind of overlay solutions that derivatives can help them implement?

Steve Morris: I agree, pension plans a number of years ago were very, very nervous about derivatives, they were focused on the control issues and the risk, but the greater awareness today has really opened up this opportunity set where clients are looking at equity futures in the example of equities, and then using that cash to deploy into short term fixed income opportunities. Another area of focuses with inflation pension plans, they're buying real return bonds to hedge inflation. And on top of those they're overlaying credit linked index derivatives. It's a very effective solution to build a synthetic corporate bond. We have a really nice liability hedge with that inflation real return bond, and then the credit spread from the index. The other area that's really growing with pension plans is the use of repo strategies or repurchase strategies. This is a traditional money market desk strategy that's enabling pension plans to do is to provide an overlay into either return seeking or additional liability hedging assets. It’s a very holistic strategy that works extremely well to address the needs for both of those total return and portfolio liability hedge areas. So, on an industry basis more and more pension clients are adopting the application of a variety of asset class solutions. The derivative tools are effective at tying everything together.

Steve Peacher: Well I’m sure this is coming across to those who are listening, but if anyone didn't think that putting together LDI portfolios for pension plans wasn't complicated now they get it. I mean you're talking about equity, equity futures, overlay strategies, synthetic corporate bonds, repo strategies, liability hedge portfolios, so it is really a Rubik’s cube at times that you're trying to put together for clients so that they're well matched versus their liabilities, but they're also generating an optimum amount of return, while they're there they're matching, so it's a fascinating area. Let me ask you on a personal level, when you're not trying to come construct these complex strategies for your clients, you know what do you do outside of outside of work to kind of keep yourself fresh.

Steve Morris: During the pandemic especially, my wife and our three daughters, we really made the best of the outdoors. Northern Canada just has great areas to explore, so we've gone on canoe trips up to the north shore of Georgian Bay. It’s a beautiful part of the world, seldom traveled and just a great area. But also going on a lot of cycling trips up in northern Ontario, and again just a fantastic place to, to spend time and really make the best of the outdoors. So, our family's been really enjoying you know this this unique time in history here.

Steve Peacher: Well, those all sound good to me and we need some warm weather to start breaking through here and then all those things can become a bit more viable as we move into summer. So, well Steve thanks for taking a moment, this is a fascinating area, the strategies that pension plans are evolving to in their LDI strategy. So, thanks for taking a moment with us today, and thanks everybody for listening to this episode of “Three in Five.”

Steve Morris: Thank you.

 

[1] Bank of Canada, 2022.

 

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