Join The Debate

JOIN THE DEBATE

CIR Online Debates explore the pros and cons of corporate credit.

Corporate bond yields have hit all-time highs. That has many plan sponsors wondering if now is the right time to invest. This was the question to hand for the second Canadian Investment Review Online Debate, sponsored by Addenda Capital, Barclays Global Investors, Crédit Agricole Asset Management and PIMCO Canada. Launched on June 3, 2009, this online forum gathered 250 invited participants from the academic and investment communities to debate the facts and assumptions around allocation to corporate credit.

During the discussion, proponents of corporate bonds claimed they are an obvious fit for plan sponsors. But others argued that asset class decisions should be longterm, not tactical. To get things started, moderator Caroline Cakebread, editor of Canadian Investment Review, posed some important questions:

• Where does the active management of this decision best lie?
• Should it be with managers or fiduciaries?
• What are the implementation concerns?

Below are the main discussion points from each side of the debate. We’ve also summarized four of the more popular position papers that we posted to help debaters make up their minds.

THE DEBATE

The Pros
Marlene Puffer, a member of the Board of Trustees for the Hospitals of Ontario Pension Plan (HOOPP) called corporate bonds “the land of opportunity.” She said the case for tactical allocation to corporate credit was quite clear, provided that careful attention is paid to liquidity, diversification and manager selection. She added that the question of active versus passive management is murkier, depending on whether corporate credit is viewed as a separate asset class or as part of fixed income. “In my view, the fixed income allocation should focus on government bonds for purposes of interest rate risk management,” Puffer said. “Corporate credit should be viewed as a separate alpha-generating asset class, but if investments in corporate bonds rather than credit-related derivatives are used, the interest rate risk component should be managed in the context of the overall fixed income allocation.”

Puffer also said that, when discussing corporate credit, one should highlight use of credit-related derivatives. “These relatively straightforward instruments can be easily used to add credit exposure,” she noted. “The use of derivatives minimizes foreign currency risk, offers good diversification in global markets beyond the concentrated Canadian sectors and can be used as an overlay strategy. Trading and settlement procedures are being revamped to reduce counterparty risk substantially, and pension committees should be better educated about the potential merits of credit default swaps and credit derivative indexes.”

The Cons
Gerry Wahl, assistant treasurer with Teck Cominco, agreed with some of Puffer’s points. When considering active investment strategies, the assumption is that active management will result in higher returns with similar risk to a passive portfolio over the longer term. But plan sponsors may have different horizons. “The short-term focus of solvency funding requirements, therefore, poses an acute financial risk for many organizations, forcing them to concentrate on solvency funding issues.” Wahl also said that the traditional role of active bond managers has been to invest across a broader spectrum of fixed income securities, managing credit, liquidity and duration risk simultaneously via a model portfolio.

“The role of the fixed income portion of the portfolio, however, appears to be changing. The critical concern is not whether active bond management significantly improves return performance but what its role is in controlling plan risk.”

Wahl firmly believes that the traditional active bond portfolio approach no longer satisfies changing defined benefit (DB) portfolio requirements, whereas having a manager responsible for a passive fixed income allocation—along with other separate credit-related (alpha-generating) sub-components—perhaps does. Noted Wahl: “A bond manager can still play an active role in the areas of duration and liquidity, adding alpha-generating components and perhaps assisting in total portfolio risk monitoring. It appears that a unique, plan-specific passive low-risk fixed income mandate, which may include passive and/or active alpha-generating fixed income components rather than a model portfolio approach, is the logical way for most DB plans.”

What plan sponsors are saying
Over the course of the discussion, members posed tough questions. Sandy McPherson, chief investment officer with the City of Edmonton asked, “should we be rather asking whether corporate bonds have a place at all within a total portfolio context?” McPherson used an example of how most portfolios hold 60% of their assets in equities already and last year was a perfect example of the “doubling-up” (or in this case “doubling-down”) that plans had with sizable equity exposure as well as corporate bonds (think default) representing a large percentage of their fixed income exposure.

Martin Belanger, associate director, retirement plans with the University of Western Ontario also noted that the type of pension plan will have an impact on the decision. “In a defined contribution environment, with no possible assetliability mismatch, it makes sense to leave the decision with the manager. Pension committees that meet every month or less cannot possibly make the right call as to when the right time is to increase your allocation to corporate bonds, on
top of lacking the appropriate expertise.”

And the winner is…
After six weeks of discussion and many guest speakers, 67% of those who voted feel that now is the perfect time to invest in fixed income. Many referred to it as an opportunity that should not be passed up.

The Position Papers

Active Versus Passive Bond Management
By Benoit Durocher, executive vice-president and chief economic strategist, Addenda Capital.

Crisis-Robust Portfolio
By Marie Brière, head of fixed income, FX and volatility strategy, Crédit Agricole Asset Management and Ariane Szafarz, professor, Solvay Brussel School of Economics and Management, Université Libre de Bruxelles.

Taking Credit in the Long Run
By Paul Purcell, senior director, institutional client relationships and Aubrey Basdeo, head of Canadian fixed income, Barclays Global Investors.

Opportunities in High-quality U.S. Credit
By Mark Kiesel, managing director, PIMCO.