LDI in a Low Yield Environment - Investment Revie · ratio portfolio Employ leverage to earn the highest rate of return LIABILITY HEDGE PORTFOLIO (LHP) PROFIT SEEKING PORTFOLIO (PSP)

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

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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


Asset Mix #1 in normal environment (equilibrium)

Asset Mix #1 in low yield

environment




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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

#

#

#

#

#

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


In normalization, breakeven increases

In deflation, breakeven decreases

24 Deflation: Even with such low yields, bonds are the favored asset class


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


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


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


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


Asset Mix in normal

environment

Asset Mix in deflation




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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

Documents

LDI in a Low Yield Environment - Investment Revie · ratio portfolio Employ leverage to earn the highest rate of return LIABILITY HEDGE PORTFOLIO (LHP) PROFIT SEEKING PORTFOLIO (PSP)