A Fixed Income Case Study: Managing Bonds in a World of Single-Digit Returns
IN PRINT ARCHIVE CIR Winter 2001
|A Fixed Income Case Study:|
|Managing Bonds in a World of Single-Digit Returns|
|Peter S. Jarvis - Vice-President, Ontario Municipal Employees Retirement Board (OMERS)|
|It is OMERS' view that the double-digit equity returns of the last decade, and of the last five years in particular, are a temporary phenomenon.|
We expect lower returns going forward, which will make bonds more attractive on a relative basis. But the question we ask is: "Can bonds pay the freight?" OMERS' pension fund requirement is to earn 4.25 per cent above the rate of inflation, which is assum-ed to be around 3 per cent, so you are talking a hurdle of about 7.25 per cent. Bond yields for the Scotia Capital Market Universe are about 5.25 per cent - not enough!
My purpose here is to examine the management of fixed income in this world of reduced returns, and the central theme is "making bonds work harder" for investors. To achieve the desired returns, fixed income asset management will become more complex. Traditional bond managers are going to find themselves challenged in this environment. And our traditional benchmarks such as the Scotia Capital Markets Universe index will also be challenged.
To achieve the returns we require, we will need to derive value-added from multiple sources. The fixed income asset class will become broader; this has already started, and the tool set needed to increase returns has generally been developed. There will be increasing use of credit, credit and more credit. I would also observe that there are few managers dedicating the time and resources necessary to be successful.
The most common instruments for adding value in fixed income have been government- and investment-grade debt, and the most important methods of adding value have been through duration, yield curve, and individual security selection. Credit work in general has been perfunctory. Moving forward, managers will have to make increasing use of securitized debt, below investment grade credit, private placements, mortgages, preferred shares, credit-backed index-based products (such as BIDS, a Scotia Capital product), options, and other overlay products. They will also use derivative products such as cross-currency asset-backed swaps and will soon use credit derivatives. Real return bonds also have a place.
The firm infrastructure requirements to competently participate in these various products are substantial. Looking at the OMERS structure of fixed income may be useful in this regard. We already participate in most of these areas with the exception of high yield or below investment grade debt and credit derivatives, both of which are on the horizon. OMERS also uses outside managers on a selective basis.
To run our fixed income department we require substantial resources. We have a vice-president in charge, a senior portfolio manager, three fixed income portfolio managers, four associate portfolio managers, and two senior analysts, one quantitative and one in credit. Six of these people are directly involved with the management of credit, which is labour-intensive and dangerous if not done well. A further three people in our mortgage department are also directly involved in our credit process (we have $1.5 billion in direct mortgages). Our activities also use a currency specialist and at least two people from our derivative department.
The point of outlining our structure is not to impress how large we are, but rather to demonstrate the depth of resources required to effectively manage fixed income assets in an increasingly complex fixed income world. Few managers are, in my view, developing that depth of understanding and resourcing. On a risk- adjusted basis, those that do and those that don't will be increasingly differentiated over the next few years.
For those of you who think fixed income in a low yield and low return world is a simple task, think again! Higher returns that are close to our return targets are available, but the tasks associated with successfully achieving those results are complex. Life is about to become more complicated. And for sponsors looking outside for fixed income management, look to the manpower and resources of your potential manager as a guide to whether they will be able to realistically produce the returns they are promising and you require. *