Investment Management Presentation tomeetings.actuaries.ca/annual/2010/Session_20_Geddes.pdf ·...

Investment Management Presentation to

Canadian Institute of ActuariesJune 29th, 2010

Presented by: Bruce Geddes, Vice PresidentPhillips, Hager & North Investment Management Ltd.

Client’s Name - 1 -Canadian Institute of Actuaries – June 29, 2010 - 1 -

Contents

Brief Review of the Investment Problem

Introduction to derivatives-based overlay strategies

Motivations for using interest rate overlays

Potential instruments for overlay construction

Derivatives Market Overview

Risk factors

Practical implementation


Framing the Investment Problem

Primary purpose of investments is to support the “pension promise”

Investment risk must relate to some measure(s) of the plan liabilities

Objective of asset mix policy is not necessarily to minimize risk but rather to measure and manage risks relative to liabilities

Investing for Plan liabilities is a process for developing and monitoring investment policy relative to some measure(s) of the plan obligations


Framing the Investment ProblemInvestment Opportunities

Minimize mismatch risk

construct a bond portfolio that delivers promised cashflows as closely as possible (ie - the Minimum Risk Portfolio)

100% government bonds (ie - no default risk)will meet benefit obligations with high degree of certainty, butlow expected return

Take on mismatch risk to try to earn higher return

higher expected returns

higher risk that benefit obligations may not be met


Fixed Income Portfolio ConstructionIs interest rate risk adequately compensated?

Duration objective:

Strategic (Policy) Target

Include nominal and real interest rate sensitivities

Influences fixed income portfolio structure

Asset / liability hedge ratio:

Proportion of interest rate risk to hedge

Influences:

Fixed income allocation and/or

Inclusion of interest rate overlay strategies


Plan Sponsor dilemmaInterest Rate Mismatch akin to Interest Rate Anticipation

This is shown for illustrative purposes only

Source: BAS-ML, Dec. 200X Bloomberg News Survey of 10-year Treasury yields forecasted to the 4th quarter of the following year.

10-Year Treasury Rates - Actual vs. Low, High & Median Estimates

6.20 6.305.90 5.80

6.106.30

6.00

5.30

5.75

5.33

4.855.10

4.804.50

3.66

4.704.30

3.55

4.30

3.603.35

1.95

5.50

4.00

5.005.105.40

2.50

3.804.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

5.00

5.50

6.00

6.50

Jan-

2001

Jul-2

001

Jan-

2002

Jul-2

002

Jan-

2003

Jul-2

003

Jan-

2004

Jul-2

004

Jan-

2005

Jul-2

005

Jan-

2006

Jul-2

006

Jan-

2007

Jul-2

007

Jan-

2008

Jul-2

008

Jan-

2009

Jul-2

009

Jan-

2010

Jul-2

010

Jan-

2011

Max. 12-Month Forecast Median 12-Month ForecastMin. 12-Month Forecast 10 Yr. Treasury Yield

# in survey 28 40 59 59 59 68 72 62 50 56


Evolution of Asset structure within LDI context

1) Traditional 60/40 asset mix

Effective asset duration ~ 2.5 years;

2) Universe to Long duration fixed income

Effective asset duration ~ 5 years;

3) Change in asset mix

60/40 to 50/50; effective asset duration ~ 6 years

4) Leveraged duration

Effective asset duration can be “customized” to Plan


Asset / Liability Hedge RatioOptions to Increase Asset / Liability Hedge Ratio

Increase fixed income allocation

reduces expected return on assets

limited impact given funded status

Duration extension

introduces yield curve risk

Overlay program

use of derivatives to maintain existing asset mix while achieving overall target asset duration

some debate as to whether this introduces leverage or not


Structuring the Liability Interest Rate Hedge PortfolioSimple, in theory

“You have your way. I have my way. As for the right way, the correct way, and the only way, it does not exist.”

Friedrich Nietzsche (1844-1900)

Increasing the Liability Hedge RatioIntroduction to Overlay Strategies


Overlay Strategies – brief look-back perspectiveNot a New Phenomenon in Canada

Prior to 2005, foreign content restrictions applied to physical ownership of foreign assets

Investors allocated assets to foreign markets beyond restriction by using derivatives (synthetic equity overlays)

Such Overlay structures allowed investors to continue to access diversification benefits and to capture potential higher long-term returns of foreign markets beyond thresholds

Typical structure: Plan took long position in S&P 500 futures contracts, backed by cash/cash equivalents

Early version of portable alpha ensued


Derivatives

“In our view … derivatives are financial weapons of mass destruction, carryingdangers that, while nowlatent, are potentially lethal.”

Warren BuffettMarch 2003


What are Overlay Strategies?

Investment strategies that utilize derivatives instruments to increase, reduce, offset or substitute certain portfolio exposures

Allows for investment opportunities beyond that which might be possible in a physical portfolio

Encompasses a broad spectrum of different applications across almost every asset class including, but not limited to:

Return enhancement

Asset mix rebalancing

Risk mitigation/hedging

Focus in this presentation will be on interest rate overlays and risk mitigation/hedging


Managing Interest Rate Risk

Traditionally, interest rate exposure of assets managed through physical fixed income allocations

Mismatch risk is introduced to the structure due to insufficientallocations to long duration assets

Overlay modifies interest rate exposure of the asset portfolio so as to more closely align it with that of the liabilities

Resulting portfolio seeks to reduce tracking error of assets relative to liabilities


Fixed Income Overlay ProgramAligning the Investment Problem to Today’s Reality

Today’s investment realityShort-term mark-to-market measures (e.g. solvency and accounting) turn the investment problem from a long-term to a short-term problem

The revised investment problem

Overlay can help to offset the market value volatility in liabilities

Overlay structures incur short-term financing costs

Non-fixed income assets now need to beat cash (implied financing)

Economic characteristics of a cash benchmark

Very little / no market value volatility

Increased volatility in annual financing cost


Illustration of Traditional Mix with Overlay Leveraged structure with lower risk profile

* The overlay allocation frees up capital for other investments. The return on the overlay = bond returns less financing** The physical bonds allocation represents the traditional 40% fixed income allocation*** The explicit objective of these strategies is to match or outperform the overlay financing cost, and implicitly to provide incremental

returns to allow plan to achieve variable liability valuation changes

Liability exposure

(Beta)

100%Physical Bond

Allocation**(Beta hedge 2)

40%

Bond Overlay

(Beta hedge 1)*

60%

Enhanced CashStrategies

(Alpha)

60%

==

++

Enhanced Cash

Explicit Role:

OutperformCash***

60%

Bonds -Physical

&Overlay

Explicit Role:Match

Valuation Changes

inLiabilities

100%

Asset structure


Interest Rate Overlay StrategiesImplications on Plan Asset Leverage

“Physical” market (ie - strips) to access duration leverage

Derivatives-based overlay structures to access duration and asset leverage

Does the overlay really result in incremental leverage?

Perhaps more importantly, is this an appropriate component in the de-risking of Plan assets?


Term Structure Implications of Overlay vs. StripsBeyond Dollar Duration Matching

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

3,500,000

4,000,000

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89Years

Nom

inal

Cas

hflo

ws

($)

LiabilitiesOverlay

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89Years

Nom

inal

Cas

hflo

ws

($)

LiabilitiesStrip Bonds

Physical Strip Bonds

Extending “Out” the Curve

Derivatives OverlayLeveraging “Up” the Curve

Mismatch Risk

Mismatch Risk


Implications of Leveraging Plan AssetsInterest Rate Overlay

Valuation changes in interest rate exposures must be assessed within asset/liability context

Even with this,

Timing of valuations differ

Derivatives have finite lives, so gain/loss realization must be factored in; implications:

LeverageBasis riskAsset disruption


Implications of Leveraging Plan AssetsIllustration – Strips versus Overlay

Asset duration target is 12 years; allocation 50%, accomplished by:

Buy 24yr physical long bonds and strips

Implement 2x12yr leveraged interest rate overlay

Assume interest rates increase by 50bps over the ensuing 12 month period;

Physical portfolio has unrealized loss of 12%

Liabilities have unrealized loss of 12%

Derivatives have finite lives, so gain/loss realization in Overlay structure must be factored in


Implications of Leveraging Plan AssetsIllustration – Interest Rates rise

What has potentially happened in overlay but not in physical portfolio?

Realization of capital losses on roll

Leverage ratio increased beyond 2:1

Or, if leverage ratio maintained, interest rate exposure going into the next period has decreased

Assets liquidated may have also fallen in valueIf sourced from other fixed income assetsIf equities/other assets have fallen in value, and are sources of required cash flow

Liabilities likely experiencing different returns – especially in reverting markets

Capacity in the Canadian Derivatives Market


The Global Fixed Income Derivatives MarketExtraordinary Growth

Source: Bank for International Settlements


OTC Derivative Liquidity

The OTC Derivative market is small and concentrated amongst the largest Canadian banks

Banks leverage their diverse client base and transaction flow in underlying bond trading to provide interest rate derivative liquidity

One measure of term interest rate derivative liquidity is liquidity in long bonds

Gross government bond issuance is projected at C$95bn in the current fiscal year (2010/11)

Expecting ~$12 billion issuance of 10 year term, $4.3 billion of 30 years, and $2.2 billion of RRBs

There are C$ 100 billion outstanding (C$ 539 billion turnover) of GoCbonds with maturities of >=10 years

OTC Interest Rate Derivative Market Small, Difficult to Measure Liquidity


Canadian OTC Derivative Markets Overview

BIS Market Survey

0

1

2

3

4

5

6

7

Forex contracts Interest ratecontracts

Equity-linkedcontracts

Commoditycontracts

Credit defaultswaps

0

20

40

60

80

100

120

Forex Contracts Interest RateContracts

Equity Contracts CommodityContracts

Credit DefaultSwaps

Total Notional Values of OTC Derivatives Held by Canadian Participants (US$ Trillions)3

Total Gross Market Values of OTC Derivatives Held by Canadian Participants (US$ Billions)3

BIS Triennial Central Bank Survey – December 20071

− Data as of June 2007

More recent BIS Report: OTC derivatives market activity in the first half of 2009 (November 2009)2

− Data as of June 2009

(1) http://www.bis.org/publ/rpfxf07t.htm(2) http://www.bis.org/statistics/derdetailed.htm(3) Charts from Bank of Canada presentation “Global OTC Derivatives Markets,” data purportedly

from 2007 BIS Triennial Survey; however, participant data is not available online

$2,604Canadian Dollar

OTC foreign exchange derivatives markets


OTC single-currency interest rate derivatives markets

Amount outstanding (US$ Billions)(adjusted for inter-dealer double-counting)

















Review of Main Counterparties in Canadian MarketCanadian banks report derivative contract notional outstanding in their annual reports

60-70% of notional outstanding for all dealers are OTC interest rate derivative contracts (see below)

3,322

1,8841,468

945747

220

0

500

1,000

1,500

2,000

2,500

3,000

3,500

RBC BMO TD Scotia CIBC National

OTC Interest Rate Derivative Notional Outstanding

C$ billions, from 2009 Annual Report Notes

Concentration issue - Canadian derivatives market share dominated by top 3 counterparties

OVERLAY IMPLEMENTATION CONSIDERATIONS


Practical implementationMacro considerations

Pre-implementation due diligence and governance framework

Defined overlay structure including instruments used

Defined implementation strategy

Risk considerations

Back-up plan


Overlay StructurePotential Instruments

Interest Rate Swaps

Bond Forwards/with Delayed Settlement/Repurchase Agreements

Total Return Swaps

Bond Futures

Instruments offer similar economic exposures, but unique attributes


Overlay StructureFactors Affecting Mix of Instruments

Market exposuresduration and term structure contributionssector/credit exposures

Market/liquidity conditionssupply/demand valuation impactfinancing/counterparty spread cost impact

Operational Riskspotential m-t-m differencesrelative rebalancing flexibility


Overlay Risk ConsiderationsSome Key Risks unique to Overlay structures

Counterparty Risk

Liquidity Risk

Operational Risk

Basis Risk

Impact of Leverage


Risk Considerations1) Counterparty Risk

More than just default risk, as much of this risk can be mitigated

Balance sheet access and implications of systemic leverage is important

Behavior of different instruments under stressed market conditions

Potential “ripple effect” of non-direct counterparty failure

Timing of counterparty event


Risk Considerations2) Liquidity Risk

Liquidity of derivative instruments themselves

Liquidity of underlying market

Degree of price taking

Relative implied financing costs of different instruments


Risk Considerations3) Operational Risk

Dedicated resources

Legal documentation

Communication

Collateral management

Appropriate monitoring of counterparty exposures

Appropriate diversification and management of risk factors


Risk Considerations4) Basis Risk

Potential for performance differential between the overlay program and the liability benchmark

Overlay portfolio will be more limited than cash portfolio in replicating beta

Certain derivatives do not exhibit expected performance under stressed market environments (financing costs, illiquidity premia, etc.)

Difficult to mitigate this problem; exists as a consequence of sourcing interest rate exposure synthetically rather than in the cash markets


Risk Considerations5) Impact of Leverage

Rise in interest rates results in a negative mark-to-market value in overlay exposures

In a stressed market environment, when combined with a loss in risky assets can magnify absolute losses to asset portfolio

Potentially requires further collateral to be posted to support overlay program at most inopportune time for the investor

An increase in systemic leverage in Canadian interest rate markets may result with the adoption of overlay programs (especially larger Plans)


Practical Implementation

Overlay should be constructed with specific reference to underlying asset portfolio

Identification of appropriate leverage ratio dependent upon ability of asset portfolio to withstand losses

Diversification (on multiple fronts) within Overlay structure iscritical


Overlay structuresSummary

Interest rate risk generally not compensated for over the long-term, so Plans should ensure Policy around interest rate matching

Overlay programs has many benefits

Brings investment problem back to beating cash

Positions the plan for introducing higher sources of return

However, they must be well understood, with heightened level of governance and due diligence required

Implementing such strategies requires increased co-ordination between clients, actuaries, investment consultants and investment managers


Thank you for your time

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