Pensions: Pensions in Peril?
While much ink is being spilled debating the impact of interest rate moves or the existence of a liquidity crisis, what is evident to investors is that an illiquid bond market benefits no one in the longer term. There is little that can be done other than grit your teeth and watch anxiously as rate announcements are made and the markets bump along. Or is there?
How are pension plan managers faring in these circumstances and how does this trickle down to the average investor?
Many pensions may not immediately feel the repercussions of this crunch; more sophisticated plans have already responded to the persistently low rates and limited liquidity by turning to alternate means of achieving long-term returns for acceptable risk. But what will happen when unanticipated market disruption occurs such as the 2008 financial crisis?
The greater challenges to liquidity are a persistent imbalance in supply and demand, the weakness in fundamental structure of the bond market, and a supply of reasonable alternatives of long-term returns to replace the traditional fixed income allocation. Helping solve these challenges could largely be a matter of technology.
Imbalance Of Supply And Demand
It’s not just a low rate environment that is the cause of this imbalance. High investor appetite for yield and low interest costs for issuers have come together to create an explosion in new issuance. Trading mechanisms in this market have simply not kept up with the growth in issuance. Additionally, regulatory changes placing new capital requirements on banks have impacted financial institutions’ ability to act as ‘shock absorbers’ in the market, causing them to hoard their capital to meet regulatory needs and adding additional pressure on supply.
A recent JPMorgan report suggests that dealers in 2014 held less than one day’s average trading volume with 90 per cent of trading happening with the top 20 per cent of bonds (JPMorgan, March 2015). Research by Liquidnet recently confirmed this trend by analyzing a random selection of U.S. corporate bond portfolios from the second quarter of 2015 and found 40 per cent of bonds are common in more than 60 per cent of portfolios.
Finally, many institutional investors like insurers and pensions aim to match longer term liabilities with the cash flow and returns generated from fixed income allocations, adopting a buy-and-hold strategy. It is estimated that close to 30 per cent of corporate debt issues in Canada are held by long-term investors (OSC White Paper, Canadian Fixed Income Market, references 80 and 81). This ‘perfect storm’ of less dealer capital, concentration of trading, and buy-and-hold investors leaves a long illiquid tail and a market ill-equipped for unanticipated market events.
Technology in fixed income markets has not kept up with the explosion of issuances, growth in demand, or improvements in technology in the investing world. Remarkably, the secondary bond market (where debt trades after initial issuance) mainly uses the same tool for facilitating trades as it has for more than 50 years – the telephone. This is akin to running a pension plan on Excel spreadsheet or calculating returns with an abacus; tools perfectly capable of doing the job are at hand, but open to error and limited in their capacity for adding insights or value to the process.
What many in the investing public may not realize is the bond market is very opaque and light on the technology needed to facilitate the trading and fair price discovery that we see in equity markets. It is truly a matter of picking up the phone and calling the right contact, who may or may not have inventory.
Valuation too is subjective and variable. Without a single source of post-trade market data for bonds (in Canada), knowing what your holdings are worth are likely dependent on who you called, how much you need, and who is buying. Trading occurs largely among dealers and buyers outside any formalized structure, which makes it not only difficult to know what inventory is available, but also may contribute to price variations, as prices are often determined through an average of sellers quotes.
While sunlight is often the best disinfectant (an often cited as a metaphor for disclosure), in this case, knowing the counterparties to a trade can negatively impact the price – a risk to larger institutional investors seeking to keep trading costs down, lessening the impact on returns.
The process is also conducted manually, adding inefficiency and risk to the transaction. It is estimated as much as 50 per cent of bond trades are conducted by phone (OSC, April 2015: The Canadian Fixed Income Market).
All of this makes finding the inventory and the true market price, at best, a challenge, not to mention the risks from information leakage.
Now, consider the possibility of some urgent change, like a hike in interest rates, turning liquidity ‘difficulties’ into a liquidity crisis for bond investors.
To the extent that pension plan managers can time their purchases, they may be beneficiaries of a liquidity crisis, buying relatively cheaply while waving at everyone running to the exits. But an unexpected market event, such as an increase in rates paid on government bonds, could trigger a move to higher-quality instruments with a newly-adequate yield at a lower risk premium.
In this scenario, two things could happen. Pension holdings would be devalued by lowered prices for bonds, affecting the implied health of the plan and, by extension, the beneficiaries. Secondly, pensions might also want to move to government bonds, either for less risk or their improved yield, joining the sellers and adding to the heightened demand.
The peril for pensions is in the devaluation of their existing corporate portfolio in a world where they cannot find a counterparty. To date, most pension plans have not managed these liquidity challenges. The role of a portfolio manager is to balance adequate returns when appropriate, with lowest risk. They are currently concerned that in that not-too-distant future, they may not be able to transact at all due to these market inefficiencies.
In a telephone-based market, their only hope may be that they get a call from a buyer’s broker who has sold the bond and now holds the risk. In that scenario, they have to compensate the broker for that risk, increasing costs, and decreasing alpha/manager returns – again, passing the additional cost down to the plan beneficiary. This is hardly the best framework for trading in one of the largest and most important asset classes in the world.
Pensions have access to other means of generating long-term returns than a traditional fixed income allocation, seeking to substitute fixed income with real estate and infrastructure investments. We read weekly about the investments of major institutional players in global alternatives that reinforce the relative undesirability of many fixed income holdings today. In an illiquid bond market, the liquidity risk of alternatives and bonds may look similar. By improving liquidity in the bond market, bonds become more-attractive.
So what is being done to address the concerns of liquidity and transparency in bond markets? Or are we doomed to a telephone based trading system for years to come?
Recently, there has been regulatory focus on structural changes that will make the bond market more technologically modern; changes that will help improve transparency, efficiency, and perhaps, more importantly, participation and confidence.
The Ontario Securities Commission released a report in April 2015 highlighting this lack of transparency and its effects on the industry at large. IIROC has begun to implement a new debt transaction reporting framework that requires all government securities distributors to begin reporting trade information to IIROC no later than November 2016 – an improvement not only to transparency and participation of retail investors, but also helping drive out imbalance and risks (IIROC website, September 17 IIROC news release, IIROC Works with CSA to Improve Access to‒ Fixed Income Market).
Some players are opening direct channels to ‘natural’ contras, betting that technology can help ease this pressure and remove intermediary risks and costs, adding that back to pensioners’ retirement funds. Technology can be the great equalizer – by adding in algorithms and logic that treats market participants equally, reducing the bias towards who you know and the unintended influence in how the trades are priced, and sharing with all parties the data on issues and inventory.
By increasing the transparency in the pre- and post-trade environments, a more sophisticated trading infrastructure creates greater visibility into pricing and trade data and helps reduce the unnecessary risks ‒ and related costs ‒ inherent in a largely manual system. The result could be an increase in investor confidence, a decrease in the cost for issuers, and, most importantly, investors helping pave the way for greater participation overall.
Robert Young is head of Liquidnet Canada.