Investing in a low interest rate environment
BY Yaelle Gang | January 23, 2019
While interest rates have risen, they remain low by long-term historical standards, causing challenges for long-term investors like pension funds.
“Because we’re a pension plan, we invest significantly in fixed-income assets,” says James Davis, chief investment officer at the OPSEU Pension Trust. “A cornerstone of our member-driven investment strategy is to mitigate the interest-rate sensitivity in our liabilities,” he adds, noting the pension fund owns a significant portion of bonds to accomplish this.
“At this stage of the game, we are probably a little light on where I would like to be in bonds over the longer term, and that’s just a reflection again of the lower interest rate environment and the need to generate returns that are sufficient to keep the plan sustainable,” he says.
The OPTrust also invests significantly in alternatives, recently internalized capital markets and is beginning to build value-add programs around its public markets exposure, notes Davis. “We’ve got value-add programs within the illiquid alternatives, where we have a long-term, successful track record, and now we’re building them in the liquid capital markets.”
This is important because in a low-interest rate environment the risk-free rate of return isn’t very high, says Davis, explaining one potential source of returns is the risk premia from investing in stocks, bonds and other capital market assets. Yet these assets are very expensive primarily because low interest rates have pushed investors out the risk spectrum, he adds. “They were encouraged to buy more risky assets, that bid up the price of risky assets, causing the expected future return to drop. So you’ve got an environment now where you’re not earning very much in terms of risk premia and the risk-free rate is not particularly high.”
The other source of potential return is value-add or alpha, says Davis. “That’s where we are putting our emphasis,” he says, noting investors can’t ignore the valuations in the market and need to have exposure to capital market instruments.
One way the OPTrust is creating value and getting exposure is through private markets. “You will get equity exposure by being in private equity, but because of the nature of how we invest, we believe that we have a better opportunity for value creation there than we would in the public equities market,” says Davis. “If you look at our overall equity exposure, which is not that high, partly because of where valuations are, partly because we’re a mature pension plan and we can’t bear that much risk, we’ve chosen to take primarily our equity exposure via the private markets for that value creation reason.”
Low interest rates also affect alternatives for the same reason they affect public markets, he says. “When interest rates are low, investors are seeking return so they will tend to move into the riskier assets,” says Davis. “The private market assets are generally a riskier asset than a bond, for example. And so when they move into that market they are bidding up the price and lowering the expected return. Just as bond yields are going down, or just as risk-free interest rates are going down, valuations in the riskier assets, including the private market assets, are going up. So their future returns are going down. And in that kind of environment, it’s just really challenging to try to get returns.”
Davis believes the best opportunities right now are in the alternatives space, despite the challenges. “We’re continuing to find, on a very selective basis, really good risk-adjusted return opportunities in the real estate, infrastructure and private equity space,” he says. “Where we think it’s more challenging is just in the conventional public market sphere — especially if you’re a passive investor. We think this is not the time to be a passive investor.”