Post on 15-Aug-2020
transcript
LDI in a Low Yield Environment
James Davis, CFA Vice-President, Strategy and Asset Mix & Chief Economist Asset Mix & Risk Department
Investment Innovation Conference San Diego, California – November 6-8, 2012
2 What do we mean by LDI?
In a perfect world we would:
Fully hedge all the risks inherent in our liabilities
Construct the optimal Sharpe ratio portfolio
Employ leverage to earn the highest rate of return
LIABILITY HEDGE PORTFOLIO (LHP)
PROFIT SEEKING PORTFOLIO (PSP)
Manage risk of liabilities, e.g., real rate sensitivity, inflation
Earn the real rate of return required to meet liabilities
Assets Liabilities
3
But Teachers’ doesn’t live in a perfect world!
4 Fast Facts about Teachers’
Largest single-profession (DB) plan in Canada; membership of 368,000 current, former and retired teachers (and their survivors)
Jointly sponsored by the Ontario government and Ontario Teachers’ Federation
Plan benefits are indexed to inflation (60% conditionally, for benefits accrued post 2009)
Need to file a balanced funding valuation at least once every three years
Requires a real return of about 5% pa to have a fully funded plan in 20 years
C$117.1 billion in net assets (2011)
200 investment professionals; investments well diversified globally, across various asset classes
Strong performance-driven, incentive-based culture
10% average rate of return and annualized value added over benchmarks of 2.3% since 1990
5 Plan demographics are impacting our investment decisions
1. Teachers are living longer and collecting pension benefits longer
2. Teachers contribute for a shorter period than they collect benefits
3. The plan is mature and will mature further
1970 1990 2011
Expected Credit at Retirement (years) 27 29 26
Expected Years on Pension 20 25 30
Active Teachers
Per Retiree
Average Contribution Rate 5.2% 8.0% 11.1%
Increase in Contribution Rate for 10% Loss on
Assets 0.6% 1.9% 4.4%
10:1 4:1 1.5:1
6 Our plan maturity makes us sensitive to the path of returns
40
60
80
100
120
2011 2015 2019 2023 2027 2031
Funding Ratio
68%
100%
Shuffled path
Return Index
0
50
100
150
200
250
300
2011 2016 2021 2026 2031
Source: Cardano, OTPP
Two paths for asset returns providing the same geometric rate of return:
Blue: Assumes actual path of MSCI returns from 1990 – 2010 is repeated
Red: Assumes four annual MSCI returns are swapped to produce early losses
OTPP is sensitive to the pattern of returns
Our funding ratio is worse if the losses occur up-front
Same starting
point
Same ending point
Same starting
point
Different ending points
Actual path
7
Benefits
Contributions
Return
Our LDI objective is a sustainable balanced plan
What a balanced plan means for us?
Earning a return high enough to ensure plan sustainability; and
Maintaining stability of benefits and contribution rates at their target levels
8 LDI means balancing short- and long-term investment horizons
Source: Bloomberg, OTPP Asset Liability Model
Risk Contribution To Liabilities*
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1 5 9 13 17 21 25 29 33 37 41 45 49
Investment Horizon (years)
Change in real yield Level of real yield Inflation
* Assuming no longevity risk* Proxied by Canadian RRBs; does not consider Plan’s demographics.
9 We cannot fully hedge our real interest rate exposure
DRIVERS:
Correlation with Plan liabilities
Risk tolerance
Level of real yields
Best hedging asset is Canadian RRBs
CONSTRAINTS:
Insufficient supply
Counterparty risk if derivatives are used
Liquidity usage
Source: OTPP
Liability DV01
REAL RETURN BONDS
Asset DV01
NOMINAL BONDS
MISMATCH TO LIABILITY DV01
10 Nominal bonds are becoming less helpful for our Plan as yields move lower
3-Year Reward/Risk for
Long Canada Nominal Bonds
3-Year Correlation Between Canadian
Nominal and Real Return Bonds
Starting yield Starting yield Higher Lower Higher Lower
Source: OTPP Asset Liability Model
11 To meet our LDI objective, we must rely on the investment attributes of a broad spectrum of assets
Key desirable asset attributes: Provide potential as a source of diversified value add
Provide stable returns
Provide long-term inflation adjusted growth
Generate cash flow
Mitigate real rate sensitivity of liabilities
Mitigate inflation sensitivity of assets or allow inflation pass-through
Facilitate leveraging
Provide reliable source of liquidity when required
LHP PSP
Nominal Cdn Bonds
Real Estate Equities
Commodities Real Return
Bonds Regulated Infrastructure
TIPS
Other Sovereign
Bonds
Growth Infrastructure
Long-Term Equities
Value-Add Programs
Private Capital
12 Asset classes behave differently in different economic environments; our asset allocation is dynamic
Economic Regime Map
High growth / Low inflation
High growth / High inflation
Low growth / High inflation
Low growth / Low inflation
GDP Growth
CPI Inflation
Equities
Corporate Bonds
EM Debt
Commodities
Inflation-Sensitive Equities
Real Estate
Growth Infrastructure
Nominal Bonds TIPS / RRBs
Gold / Precious Metals
Regulated Infrastructure
13 Our Asset-Liability Model allows us to do “what-if” scenarios …
18% 20% 22% 24% 26% 28% 30% 32% Increasing Worst Case Contribution Rate
Asset Mix #1 in normal environment (equilibrium)
Asset Mix #1 in low yield
environment
WORST: Higher Worst-Case Contribution Rate
Higher Average Contribution Rate
BEST: Lower Worst-Case Contribution Rate Lower Average Contribution Rate
Dec
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Co
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RISK
REW
AR
D
A low yielding regime is detrimental to our goal of stability and sustainability
14 … and to identify better asset mixes to improve our reward-risk tradeoff
18% 20% 22% 24% 26% 28% 30% 32% Increasing Worst Case Contribution Rate
Asset Mix #1 in normal environment (equilibrium)
Asset Mix #1 in low yield
environment
WORST: Higher Worst-Case Contribution Rate
Higher Average Contribution Rate
BEST: Lower Worst-Case Contribution Rate Lower Average Contribution Rate
Dec
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Co
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ibu
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RISK
REW
AR
D
Asset Mix #2, #3 and #4 in low yield
environment Our objective is to move
to the upper left by improving our asset mix
A low yielding regime is detrimental to our goal of stability and sustainability
15 Five reasons why the current low yield environment could be with us longer than we would like
1. Historical precedent
2. Low rates are necessary
3. Demographics
4. De-risking and risk management Risk parity / Bonds as insurance
LDI
5. Policy induced regime changes Deflation
Financial repression
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#
#
16
Historical US 10-year Real Yields*
*Breakeven inflation is proxied by 10-year moving average of
realized inflation.
Source: OTPP, Global Financial Data
#1: There is a historical precedent for lower yields
Historical US 10-year Nominal Yields
+ s
Post WW II
WW I
Great
Depression
Post WW II
- s
+ s
- s
17 #2: Low yields are justified by current conditions
Source: Federal Reserve, Bloomberg, OTPP
US Monetary Aggregates
$ Billion
Money Supply: M2 to M0 (Ratio)
M0 (R)
Ratio of M2 to M0
18 #3: Demographic trends support lower yields
US Labor Force Participation Rate
US Real Yields and Demographics*
(from 1981 to 2012)
%
%
Source: OTPP, BLS, Global Insight
*Ratio over 65 years old to 15-64 years old
19
Correlation Between US Stock and Bond Returns
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
87 89 91 93 95 97 99 01 03 05 07 09
Historical Correlation
3
4
5
6
7
8
9
Percent
Rolling 5-yr Correlation
10-yr Bond Yield (RHS)
#4: Nominal bonds are a good tail risk hedge even at low yields
ρ = -0.67
Source: Global Financial Database, Global Insight, Shiller, OTPP
Shiller P/E vs. 10-year Bond Yields
Less Diversification
More Diversification
0
5
10
15
20
25
30
35
40
45
50
2 4 6 8 10 12 14 16
US 10-Year Yield, percent
Shiller P/E
ρ = +0.82
20 #4: Many DB plans are waiting to de-risk
Source: Morgan Stanley
Funding Ratio Sensitivity Analysis
21 #5: Two different macro economic regimes can lead to yields remaining low or even heading lower
Economic Regime Map
GDP Growth
CPI Inflation
Nominal yield > Nominal GDP
Inflation < target
Arises from a policy mistake, e.g., austerity
Nominal yield < Nominal GDP
Inflation > target
Arises from a deliberate policy choice, e.g., inflate away debt
2. FINANCIAL REPRESSION
1. DEFLATION
22 Deflation: Two historical examples
Source: Global Financial Data, DataInsight
Yields too high relative to GDP
Very low inflation
Yields too high relative to GDP
Very low inflation
23 Deflation: Our simulated scenario reflects a sustained period of extremely low yields
Source: OTPP Asset Liability Model
In normalization, breakeven increases
In deflation, breakeven decreases
24 Deflation: Even with such low yields, bonds are the favored asset class
Source: OTPP Asset Liability Model
Simulated Asset Class Real Returns Policy Asset Mix Under Different Scenarios
25 Financial Repression: The US experienced financial repression post WWII
Source: Global Financial Data, CBO
Yields too low
relative to GDP
High inflation
%
%
US Debt-to-GDP
US Financial Repression
(1946-1952)
Due to financial repression, debt
declined by 3-4% of GDP per year.
26 Financial Repression: Our simulated scenario reflects a sustained period of extremely low yields
Source: OTPP Asset Liability Model
In normalization, breakeven increases
In financial repression, breakeven increases
27 Financial Repression: Higher inflation and moderate growth favor commodities and real assets
Simulated Asset Class Real Returns
Source: OTPP Asset Liability Model
Policy Asset Mix Under Different Scenarios
28 In both low yield scenarios, our expected returns fall short of what we require to meet our liabilities
Source: OTPP Asset Liability Model
Real Yield
at t=10 -1.3% 0.5% 2.2%
29 Improving the asset mix will help but will not likely be sufficient if these scenarios come to pass
18% 20% 22% 24% 26% 28% 30% 32% Increasing Worst Case Contribution Rate
Asset Mix in normal
environment
Asset Mix in deflation
WORST: Higher Worst-Case Contribution Rate
Higher Average Contribution Rate
BEST: Lower Worst-Case Contribution Rate Lower Average Contribution Rate
Dec
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Improved Asset Mix in deflation
Asset Mix in financial repression
Improved Asset Mix in financial repression
30 Some positive signs: De-leveraging is progressing and policy makers have made credible decisions … so far
Vows not to repeat the
mistakes of the 1930s Whatever it
takes Pace of austerity
must depend on
economic conditions
Committed to
European unity
31 Key takeaways
Plan demographics and market constraints pose significant challenges
Our liabilities are large and are very sensitive to real rates
Our plan maturity makes us increasingly less tolerant of volatility
Our LDI objectives of stability and sustainability become more difficult to achieve in a low yield environment
There are several reasons why yields could remain low
Different low yielding environments necessitate very different asset mix responses:
Deflation favors bonds or assets generating high quality cash flows
Financial repression favors real assets and commodities
Smaller plans should consider having exposure to high quality higher dividend yielding stocks and inflation sensitive equities