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Benefits and Pensions Monitor

A Case For Global Bonds

By: Richard Bernard

The recent budget tabled by the federal government made headlines for different reasons, but the proposed elimination of the 30 per cent foreign content restriction for taxexempt retirement funds has caught the attention of investors.

Although Canadian pension plans have been able to circumvent the foreign content limits through the use of swaps and clone funds, most plan sponsors have stayed within the 30 per cent limit. With the proposed amendment to the Income Tax Act, plan sponsors are now looking into their investment allocations and wondering if any changes should be made. Will the addition of a global bond mandate be the next major move by plan sponsors?

Historical Asset Allocation
The evolution of investment policy of Canadian pension plans has resulted in a concentration of asset allocations in the area of about 60 per cent equity and 40 per cent fixed income. This was driven by actuarial considerations, risk/reward characteristics of various asset classes, geographic diversification considerations, and the 30 per cent maximum on foreign content. The typical equity component has approximately 35 per cent allocated to Canadian equities, 12.5 per cent to U.S. equities, and 12.5 per cent to international equities. The 40 per cent allocation to bonds has overwhelmingly been restricted to Canadian securities. This allocation has become so mainstream it represents the benchmark for a majority of pension funds and balanced pooled funds.

Looking Ahead
For the last 25 years, financial markets have been dominated by the impact of persistently declining interest rates. This resulted in an environment of high absolute and positively correlated equity and fixed income returns.

The next decade will likely present a very different investment landscape. Stock and bond returns will likely revert to a more normal pattern of low or negative correlations and, given the low level of interest rates and lower nominal GDP growth, this will likely result in single digit investment returns for both asset classes.

In this environment, dynamic asset allocation and alpha generating strategies will garner more attention. Given this environment and the prospect for the elimination of the foreign content limitations, it may be the time to explore the addition of global bonds to an investment mandate.

Why Global Bonds?
The addition of a global bond mandate brings significant diversification and risk reduction to a portfolio given its low correlation with conventional asset classes. Global bonds include sovereign bonds and corporate bonds along with currency diversification without the equity risk. Given the moderately illiquid nature of the Canadian bond market, global bonds also provide access to more liquid markets.

As shown in Exhibit A, the spread in returns of bonds in different countries is substantial. This volatility can be translated into an alpha generation opportunity by a skilled investment manager. This increased opportunity set, combined with low correlations, is the major attraction of global bonds.

As with any strategy, the risks must also be considered. The level of returns is highly impacted by currency movements. Additionally, when assessing global bonds from a purely asset return perspective, the volatility has been significantly higher than with domestic bonds and has negatively impacted Sharpe ratios. In an asset/liability framework, global bonds have experienced a higher tracking error relative to liabilities.

Considerations In Adding Global Mandates
There are some issues to consider when implementing a global bond mandate:  What type of risk/return framework are you managing – asset values or funding levels? From an asset perspective, the addition of global bonds will likely reduce the risk given the lower correlation. From a funding perspective, the duration impact relative to liability durations will have to be considered.

• Should the currency impact be passively hedged or actively managed?
• Should the country allocation be passive or actively managed?

Global bond mandates come in many shapes. In the case of a passive strategy, there is more than one benchmark to consider. In the case of an active strategy, the sources of alpha generation should be aligned with the objectives and constraints of the investment policy. Should the mandate exclude Canada? The case for excluding Canada is that portfolios already include Canadian bonds. On the other hand, an ex- Canada mandate reduces the capability of the manager to add value if, in his view, the greatest potential is in Canada.

The need for customized and unique solutions by plan sponsors is becoming more important. Given the current investment environment and considering the challenges ahead, global bond mandates may have a place within many investment structures as the demands for diversified sources of alpha and effective risk management increase.

Richard Bernard is director, institutional client service and marketing, Legg Mason Canada Inc.

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