Reduce your bond exposure and seek broader diversification

By Rob Boston, Managing Director, Morneau Shepell Asset & Risk Management Ltd.

Endowments and foundations (E&Fs) are interested in predictable income to satisfy their spending requirements while protecting against loss of principal.  Historically, high quality bonds, held to maturity met this need. The total return of a bond is comprised of the yield from the coupon plus the change in price of the underlying bond in reaction to changing interest rates. Over the past 30 years, interest rates have generally followed a downward path; that has been a positive environment for bond prices: when interest rates go down, bond prices go up.  As a result of the interest rate trend, the long-term historical return of the bond universe in Canada has been about six per cent. Considering the long term required return for most E&Fs is about six per cent; the inclusion of bonds in the asset mix makes sense.  

But what about the next 20 years?  

However, the interest rate trajectory cannot be sustained forever.  Given where interest rates are today, the forecast return for bonds over the next 15 years is a little better than three per cent1. The rationale for E&Fs to include bonds in their portfolios has diminished; funds receive a predictable income and return that does not meet their required long term return. Bonds will be nothing more than expensive diversification tools – providing only 50 per cent of the desired return.

This chart shows the decline in the implied yield on 10-year bonds.
 

Options for endowment and foundations bonds

One option to deal with the return shortfall is to allocate less of the overall portfolio to domestic bonds and look for higher performing bond or bond-like investments elsewhere – both geographically and from an asset point of view. This could include global bonds, emerging market bonds, high-yield bonds or mortgages. Some alternative assets like core real estate and core infrastructure, which obtain the majority of their return through income, behave like bonds, provide more predictable sources of income (versus equities) and should be considered as well.

The second option for funds is to obtain a better return from other parts of the portfolio. However, this is equivalent to saying you are willing to get to the return target with one arm tied behind your back. The pursuit of higher absolute returns for the remaining portion of the portfolio (normally in stocks) will likely entail more risk which may not be palatable.

Happy medium for institutional investors

There is a happy medium for institutional investors. By reducing Canadian bond exposure, diversifying into other bond and bond-like instruments, and seeking broader diversification of the entire stock portfolio investors can ensure proper diversification and risk balances to meet portfolio obligations.   There are providers that pool the assets of smaller investors to obtain the economies of scale such that Canadian bonds will eventually become an unattractive option for meeting an E&F’s spending target.  Investors have options that will give them a bigger bang for the buck without ballooning their risk budget.


1    Morneau Shepell Actuarial Forecast

Rob Boston is Managing Director, Morneau Shepell Asset & Risk Management, a wholly-owned subsidiary of Morneau Shepell. Rob is also Chair of the Morneau Shepell Socially Responsible Investing Team. rboston@morneaushepell.com

About Morneau Shepell Asset & Risk Management Ltd.

Established in 2012, Morneau Shepell Asset & Risk Management was launched as an extension of Morneau Shepell’s asset and risk services department to help achieve targeted investment outcomes for clients and provide pension plan sponsors with a new investment approach and asset allocation. By pioneering the outcome-oriented style of investing, Morneau Shepell Asset & Risk Management assists investors by emphasizing downside protection, reduced volatility, and controlled risk. For more information - morneaushepell.com/arm.