In today’s low interest rate environment, passive approaches to liability-driven investing (LDI) may leave plan sponsors either behind in meeting return targets or forced to stretch risk to achieve it. Instead, we believe active strategies, if conducted in a risk-aware framework, can help enhance total and risk-adjusted returns. In this Q&A, Vinayak Seshasayee, lead portfolio manager in Canada, and Vijendra Nambiar, pension solutions strategist, outline PIMCO’s investment approach and its potential for generating alpha.

Q: LDI is considered a de-risking strategy – why is alpha important?

A: We think alpha is crucial for the following reasons:

Alpha generated in a prudent and risk-aware framework could allow plan sponsors to target similar levels of returns while lowering overall funding risk relative to liabilities. As Figure 1 shows, a passive approach to LDI can leave pension plan sponsors stretching for returns in volatile asset classes like equities, resulting in much higher overall funding ratio risk at the plan level. If a plan’s fixed income portfolio can deliver 75 to 100 basis points (bps) of alpha, for instance, plan sponsors may be able to reduce equity allocations, thus lowering that funding ratio risk.

Viewed from another lens, every basis point of fixed income alpha added to LDI portfolios is accretive to funded status, especially in a world of lower long-term expected returns. As Figure 2 shows, active risk in an LDI fixed income portfolio may have a very minor impact on overall funding ratio risk, while the generated alpha may materially improve overall plan level returns. Thus, active fixed income alpha could permit plan sponsors to potentially contribute less to their plan and manage their plan economics better, both now and in the future.

Q: Can alpha be consistently achieved in Canadian long-bond portfolios?

A: In Canada, the broadest long-bond indices include meaningful exposures to the federal, provincial, and corporate sectors. We see a wide range of opportunities to outperform the index in a diversified manner, while incorporating balanced positioning across top-down/macro views and bottom-up security selection. These levers include, but are not limited to:

• Sector and credit selection in Canadian provincial and corporate bonds
• Harvesting structural inefficiencies that exist within the index
• Opportunistically taking advantage of concessions both in new issue and secondary market
• Broadening the opportunity set in credit beyond the small and concentrated pool of sectors and issuers in Canada to a global one
• Managing yield curve exposures optimally through the cycle, based on relative value and return expectations

Q: How do you apply PIMCO’s investment process to Canadian LDI portfolios?

A: PIMCO manages long-duration portfolios by combining our rigorous active management process for total return fixed income with the needs of liability-driven investors. Our process combines fundamental credit selection with the top-down insights provided by our cyclical and secular forums. The forums distill our broad outlook for the global economy and markets, including the distribution of risks around that outlook. These insights help us determine how to position our portfolios relative to their benchmark. They also help determine what sectors and industries we will invest in, and those we will avoid. These model portfolios are refined with real-time information from Investment Committee meetings that happen several times a week.

Within the structure set by our model, our positioning is driven by our bottom-up credit analysis. PIMCO’s size and scale enable us to conduct rigorous bottom-up credit analysis on an exhaustive range of global issuers across corporate credit, securitized products and emerging markets. Our team of over 75 credit analysts^Footnote1 assigns independent ratings to issuers and securities, limiting reliance on external agencies. In recent years, we have used our scale and position in the credit markets to add value in novel ways, such as by partnering with companies on reverse inquiries, or by providing liquidity to the market on select opportunities.

We augment this process by taking advantage of structural opportunities identified over years of research and practice. Furthermore, our investment process is governed throughout by a robust risk management framework. We believe that by diversifying strategies and relying on multiple sources of value, we can seek excess returns with a high degree of consistency.

The flexible nature of our process has helped us to add value not only against broad market benchmarks, but also tailor value-added solutions to meet the unique liability needs of individual clients. Our active LDI practice serves a range of plan sponsors, including corporate pensions, public plans, and universities.

Q: How do you incorporate LDI-specific considerations when building Canadian long-duration portfolios?

A: At PIMCO, our active management philosophy is built around a thorough understanding of the risks embedded in the liabilities and the selected market benchmark– i.e., we are cognizant that we must apply our alpha-generation process not against random targets or indices but against goals that are aligned with our clients’ liability-management objectives. This allows us to customize portfolio benchmarks, targets, objectives, and risk tolerances. Said another way, this is a no-cutting-corners approach that is integrated into the pension solution’s design as well as the management of the portfolio so that asset-liability integrity can be maintained.

We are also mindful of several aspects of the market that make it imperative for us to be accurate in our credit selection. For one, long-duration sectors tend to have lower liquidity and higher transaction costs than other market segments. We are also lending money for long periods of time. These factors magnify the potential negative impact of mistakes in credit assessments, or unforeseen downgrades. Hence, thorough credit research is especially important in our LDI process.

Q: How do you take into account the concentrated nature of the Canadian corporate bond market when managing long-bond portfolios?

A: One of the oft highlighted frustrations about the long-duration Canadian bond market is the concentrated nature of its issuers, and the relative lack of diversification – a few sectors account for most of the Canadian bond market’s credit exposure. That makes the market vulnerable to a fundamental weakening in one sector. A key differentiator of our LDI strategy is that it allows us to capture opportunities globally, which helps us build a more diversified portfolio while seeking to mitigate foreign interest rate and currency risks. This is especially important in LDI, where sponsors look to maintain a close match with liabilities. Therefore, any addition of active risk must carry a high information ratio. Given the domestic nature of plan sponsor liabilities, we seek to limit our use of unhedged currency exposures or significant interest rate mismatches.

Q: PIMCO is a large player in the fixed income markets. Is this an impediment to adding value in these portfolios?

A: Absolutely not – we view our size as an important advantage for clients. It allows us to deploy human capital and analytics resources to cover a much broader universe of investments, and quickly respond to market opportunities.

With potential deterioration of credit quality always a threat, managers like PIMCO with substantial scale and deep credit research and portfolio management resources can have a potential edge in accessing credit investments, and avoiding impairment risk. We have deep and long-standing relationships with bond issuers and remain in dialogue to help these companies with their financing needs.

Our scale and size also help us to take advantage of market inefficiencies and anomalies, what we call “structural alpha.” These include relative value opportunities between “on the run” and “off the run” bonds, and opportunities around large index-rebalancing events or new-issue concessions, which are ever present in the Canadian bond market. We apply a disciplined and consistent approach to identifying and capturing these opportunities in our portfolios. In the long run, we have found that these opportunities tend to be a consistent source of excess return, often incurring relatively low tracking error costs.

Q: What does the future look like for active LDI in Canada?

A: The coming three to five years will likely present unique challenges, not just for fixed income, but for asset allocators more broadly. Return expectations across many asset classes may be lower than in the past decade. In Canada, interest rates have risen sharply, and the FTSE long-term bond index now yields 2.9% (as of 18 March 2021), up from barely 2% at the start of this year. This is a material increase, and could improve prospective returns, but the long-term bond yield remains low by historical standards. Additionally, several other secular shifts, such as those brought on by climate change, present both threats and opportunities for portfolios.

In this environment, we believe the role of active LDI bond management will likely be enhanced, as the potential contribution of alpha becomes a larger share of total portfolio return. We strongly believe that the scope for adding value through a structured and rigorous active process, such as PIMCO’s, is as robust as it has been over the past two decades, even as expected beta returns may have dwindled. With our vast resources – over 260 portfolio managers^Footnote2, a wealth of external advisors, investment strategists, and our client service teams, we are thrilled about the alpha opportunities in the current environment.

¹As of 31 December 2020 Return to content↩

²As of 31 December 2020Return to content↩