Vice President, Interest Rates & InflationHOOPP
A Conversation with Ray Tanveer on Interest Rates and Inflation
For the Healthcare of Ontario Pension Plan (HOOPP), investing in Fixed Income has been strategic in its LDI (Liability Driven Investing) approach. “We have been a relatively unique outlier in the use of Fixed Income for pension planning”, says Ray Tanveer, Vice President, Interest Rates and Inflation, who joined HOOPP in mid 2007 as a PM after 15 years in proprietary bond and interest rate derivatives trading at some of the major banks. “Our Plan’s management and board modified the Fund’s asset mix at the policy portfolio level by increasing allocation to Nominal and Real bonds while simultaneously reducing Public Equities during the summer of 2007. That very timely ‘de-risking’ helped the Plan weather the big 2008-2009 financial crisis relatively well.”
In late 2012, HOOPP started to further add to fixed income “in order to lock in decent government bond yields and to mitigate risks to our favorably funded status,” Ray explains. “We’re not only an Asset Manager. We’re a Liability management organization as well. Our primary job is to keep the pension promise to our plan members. When long maturity bond yields go down, plan liabilities get discounted at lower rates and those liabilities go up. And, all things equal, funded ratios go down and the ability to remain favorably funded is reduced.”
On the topic of pension plans using leverage, Ray explains “as you mentioned, as is publicly known, our policy portfolio is levered. Leverage is applied, our bond portfolio is increased – was increased – and it allowed us to add to investments in other asset classes with materially higher expected rates of return such as real estate, private equity and debt, infrastructure as well as newer absolute return strategies – all while maintaining exposure to traditional asset classes such as public equities and credit through the use of derivatives. If you add up all the percentages of various asset classes in our total portfolio, it’s more than 100% of NAV. That leverage helps enhance our expected rates of return. It also helps enhance portfolio diversification and resilience while helping to reduce funded ratio risk and liquidity risk.”
The function of Fixed Income in the HOOPP total portfolio has been “multifaceted, beyond just providing government-guaranteed rates of return,” according to Ray. “Besides having served as a dynamic ‘liability hedge’ which has been thoughtfully modulated over rate cycles for the benefit of the Fund’s returns for more than a decade, it’s also been a ‘risk asset’ hedge. Sovereign government bonds also provide high quality collateral and liquidity in times of stress – such as this past March – and the asset class has also proved to be an important source of Value-Add or Alpha for the Total Fund through active portfolio optimization and intra-asset class factor management, including inflation, as well as through its employment as collateral in funding-related activities.”
Fixed-rate bonds are a significant percentage of HOOPP’s government rates portfolio but returns are not coming from the nominals sector of the market alone in this environment, Ray indicates. “Over the past few months, real return or inflation-indexed bonds have provided even better returns than nominal fixed-rate sovereign bonds for investors in this asset class and to those employing inflation breakeven overlays.”
In recent months, central banks in Canada and U.S., among other countries, have been purchasing government and corporate bonds on a massive scale. On whether that will trigger an inflation or deflation scenario, Ray says, “as alluded, we take views on inflation expectations. The oft-mentioned output gap and large supply of labor due to COVID-19 driven lockdowns and job losses is theoretically disinflationary. But, unprecedented policy accommodation and stimulus – especially the size, breadth and speed of the Fed’s response and the monetary and fiscal measures and programs implemented by other major central banks and governments globally – well, they are designed to generate reflation in order to achieve their stated longer run targets on CPI, unemployment rates and other such metrics.” These activities reflect governments’ decisions to run massive deficits to stimulate economies. The monetary policies of large asset purchases or QE and zero rates in North America are meant to ultimately bring unemployment rates down. They provide market stability in the meantime.
Talking about challenges, Ray, who is also a member of HOOPP’s Asset Mix Committee, ponders, “under the current interest rate environment of roughly 1% longer maturity federal government bond yields, how do you achieve the 5 – 7% annual returns required for plans to sustainably pay pensions over the long run? It means having a somewhat leveraged policy portfolio which allows for the increase in allocation to other asset classes with materially higher expected rates of return, including targeted investments in real estate and public equities, selective investments in private equity and debt, infrastructure, credit and other absolute return strategies. We’re looking at other scalable investment opportunities as well. Within government bond space, it means more sub-sovereigns, select foreign sovereigns and probably more inflation-indexed bonds, especially if you’re managing inflation-sensitive or CPI-related risk factors. It means harvesting risk premia over time. But, really, the offset in reaching for extra returns, including the degree of leverage a plan is willing to employ and the increased allocation to other asset classes, is more risk. You’re adding riskier assets to the portfolio and – depending on which method you decide to choose – probably reducing portfolio liquidity, at the margin. So, then, Its also about Plan architecture and infrastructure and the ability to remain relatively liquid to finance investments and being able to operate efficiently in securities lending and borrowing markets. And, of course, it’s about strong risk management, technology, good governance and oversight and keeping ourselves educated on an on-going basis. It’s all a finely-judged balancing activity which needs to be dynamic as markets change and evolve – as LDI changes and evolves.”
Looking into the future, Ray cites things like the roughly $4 trillion US budget deficit and the $343 billion deficit that the government of Canada recently reported, compared to the $50 billion deficit at the time of the 2008-2009 financial crisis. “There is really no way that the Fed and the BOC can lift from zero lower bound and taper off QE anytime soon. With governments running extremely large budgetary deficits and debt-to-GDP ratios, their central banks need to keep all borrowing rates or costs as low as possible for as long as possible. The Fed is also mandated to maintain policy accommodation until the US reaches full employment – so, as alluded to by some of the Fed governors themselves, they’re willing to let average CPI temporarily trend above target over shorter time horizons in order to achieve their longer run employment goals ”, Ray concludes. “That will bring stability out to intermediate maturity bond yields but some investors will be required to take on more term risk out the yield curve in the face of increasing supply and reflationary policy measures while others will also have to look at adding riskier debt securities. And, of course, long term investors will have to allocate more of their total portfolios to other traditional and less traditional return-seeking asset classes, both liquid and less liquid. The Fed is basically giving investors little choice other than to take on and manage more risk. It’ll be important to be thoughtful, flexible and patient with a highly experienced, adaptable, collaborative and knowledgeable team surrounding you.”
*The article is updated on August 12. Any quotes of numbers are as recent as the date of the article.
Ray Tanveer, Vice President, Interest Rates and Inflation, HOOPP, spoke at Institutional Connect Virtual Forum in October 2020.