Steve Peacher: Hi everybody, thanks for dialing into this episode of “Three in Five.” This is Steve Peacher at SLC Management. And today I'm really happy to be joined by Veronique Lauzière, who represents SLC in the province of Quebec. So Veronique, thank you for taking a few minutes.
Veronique Lauzière: Thank you for having me. That's great.
Steve Peacher: So, today we want to talk about something that's been, we've been focused on as a firm for many years, liability driven investing or LDI. It's been a concept that has been, I think, actively pursued among many Canadian pension funds for many years. But there's change happening in that, in part due to the underlying environment, especially the interest rates, level of interest rates, shape of the curve. And that's what we want to talk about. Let me just start at the high level. Why is LDI, liability driven investing, so relevant now in this environment? What's changed?
Veronique Lauzière: Good. Yes. Thank you. And so maybe I'll just start by defining what liability driven investing means, because it can mean different things to different investors. And there's many interpretations about how you do it, but it generally means you're investing while being aware of liabilities. With the recent bank crisis, the importance of that framework came to the forefront as we've seen that the type of trouble that can be caused by an asset liability mismatch. So to be clear, I'll be commenting from a Canadian market perspective, but there's a lot of similarities with the U.S. Number one reason why LDI is relevant today - recent rate increases. So, in the past year, the Bank of Canada raised rates by 425 basis points. A hike like this has not been seen in recent history. So, as a reminder for the listeners, as rates go up, bond prices go down, which means that bonds are now cheaper than they have been in quite a while.
For plans who are looking to derisk, this is an attractive entry point. But I should point out that we don't know how long it will last, as these opportunities have been historically short lived. The number two reason I would say it's financial health of pension plans. In 2022, we saw a dramatic downturn in equities and fixed income, which has shocked many investors. But in spite of this, pensions plan are still in good positions because they had good returns prior to last year. So this puts them in a very strong, I should say it's probably stronger than ever, financial position. So they can now afford to de-risk by locking in some of these gains. And finally, the third point I'll make is it's more of a broader theme about demographic trends. Pension plans are maturing, which means that there are more retirees and fewer workers in these plans. So as a result they have more pensions to pay and they need their asset mix to produce more stable and certain cash flows. And where do stable and certain cash flows come from typically? It's from fixed income. LDI is not just about fixed income, but it's an important building block of these solutions. So, if I want to sum it up, it's an opportune time for to implement or revisit an LDI program. Pension plans can afford it, and they also have a greater need for it, generally speaking.
Steve Peacher: So, if a plan is considering implementing an LDI approach today, what are they looking to get out of that? What is their goal from an LDI solution?
Veronique Lauzière: Yes. So I think first, like LDI has evolved, we should note that it was, it used to be more of a simple bond portfolio and now it's more like a broader framework. It means that we're considering the whole portfolio together with liabilities when we are constructing a solution. I'll give you a very simple example. Infrastructure and real estate, they were not considered in the LDI portfolio in the past, but now investors are starting to recognize the benefits of these two assets in managing liability risks, such as inflation for example. So investors are looking outside of traditional fixed income when they think of LDI. So they think of it more as a framework covering more types of assets. Secondly, pension plans have generally categorized assets into two categories, so liability hedging assets and growth assets. So in the past these two buckets, they had very specific roles that were distinct from one another. Liability hedging meant bonds to replicate liabilities. The growth assets meant equities, and their role was to generate excess return. As I explained before, because plans are maturing, the liability hedging bucket now represents a bigger share of the total portfolio and the percentage of growth assets is diminishing as a result. This means investors are demanding higher return from that bucket, from that liability hedging bucket, to maintain an overall interesting return profile.
Steve Peacher: So when you put it all together, given this broader framework that you mentioned, you know, when you, and plans are trying to put this all together, you know, how are they going about accomplishing, you know, implementing an LDI approach in their portfolios today given the changes that you talk about. The fact that you could consider broader asset base, the fact that interest rates are at a different level, the fact that plan funded ratios are actually better. So, how are they going about this?
Veronique Lauzière: One key thing is that, as I mentioned, liability hedging bucket, there's a greater need for return in that bucket. And so there are a couple of ways investors actually trying to get more returns from that bucket. And for instance, they try to go deeper into credit. So they are still being prudent in their risk they're taking, they're diversifying it as well, properly. But for example, we see below investment grade now being part of the LDI framework. This has the benefit of boosting returns, but also it acts as a diversifier to traditional investment grade credit. Another way that they can try to boost their returns is by seeking liquidity premium from things like private debt when they it's possible to add such a such an asset class. Private debt is very similar in many ways to public debt, but you do get a risk premium due to the asset being liquid and having multiple barriers to entry. Canadian pension plans generally seek Canadian fixed income products, but the one thing here I'll mention is that it's important to understand that the Canadian corporate bond market is quite limited, and especially so in the long end where many pension plans want to invest. So, investors are addressing this in one of two ways. Either you buy shorter term Canadian bonds and you add leverage to get to your longer duration. Or you can try to use other markets. So, for instance, you can buy a longer dated U.S. bond and bring it back to Canada by hedging the interest rate and the currency risk through the use of derivatives. So what you're essentially doing is that you're isolating the credit risk of the U.S. bond. And then by combining it to a Canadian federal bond, you create what I like to call a synthetic Canadian corporate bond. So, like, to sum this all up, I think this is a really exciting time for pension plans to reconsider their derisking journey and their LDI portfolios. There are many tools available. Innovative strategies and the solutions are more accessible than ever. I've heard you say on another episode that income is back in fixed income, and I think that creates a ton of opportunities that have simply not been there in the past ten years. So, I think we're going to go to hear more about what an LDI framework can do for pension plans in the next couple of months.
Steve Peacher: Well, you know, the last 20 to 30 years in some respects has been a very challenging environment as plan CIOs and oversight boards have considered LDI because what I've seen investors over the years say is, ‘yeah, it makes sense but geez rates have come down’ because rates have been until recently, been on a steady downward path. So it's been common to see plans say, ‘well, I'm just going to wait till rates come back up’ and then they don't get the chance. And then the more rates came down, the more painful it was for a plan that had not implemented an LDI solution because declining rates are difficult for long dated pension plans. You know, to some extent this is the chance, right?
Veronique Lauzière: Exactly.
Steve Peacher: We're finally seeing that increase in rates. And so for plans that had not implemented an LDI solution years ago and were looking for the opportunity maybe this is it.
Veronique Lauzière: Yea.
Steve Peacher: And I think to some extent we're trying to ring that bell in saying not only is are you getting the chance that you haven't had, but there there's a broader way to think about it. And you can and you can think about using new asset class in a hedging manner with more returns. So it's actually a very exciting time to be thinking about this. So, you know, it's a big topic. We could spend a lot more time on it, but those are really good insights. Let me completely shift gears. I like to end with a question that has nothing to do with our topic but something on the personal front. So I know that your family has a sugar shack that they've managed, it sounds like, for a long time. So, tell everybody about that.
Veronique Lauzière: Sure. Yes. So it's in my husband's family. It's a is actually is his grandfather and his uncle who owned the sugar shack. But we have a beautiful place, the reds shack out there that that is really the place for the family to all come together. And every season, like the springtime for us, the beginning of the springtime, really means season for maple syrup. And so we all gather there and help somehow in getting all of that water to the boilers and the and enjoying a lot of sweets that come out of the maple syrup. So, it's very, a good family tradition, but it's also one that is very enjoyable for the kids and a good moment in the year to really spend time out there outdoor.
Steve Peacher: And does that make this maple syrup that your sugar shack end up getting distributed, sold? And for those of us who are down in the states would any of this be coming our way or is it just around you?
Veronique Lauzière: So it's kind of a small shack. So you can, like, we cannot distribute more widely, but we have this big thing in Quebec where we have a federation as well where you give a portion of your production to in exchange for a stable price on maple syrup. So, that's also another way that that you can access the Quebec maple syrup. But I surely have a lot of friends and family that benefit from the maple products around me.
Steve Peacher: Well, that's fascinating. Well, listen, thank you Vero for taking the time. You know, it's a big topic. I know as a firm we think this is really something that pension funds should be thinking hard about because there are great opportunities in this market and those haven't necessarily been available over the last few years. So it's really an important topic to be talking about. So thank you very much.
Veronique Lauzière: Thank you for having me.
Steve Peacher: And thanks, everybody, for listening to this episode of “Three in Five.”
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