Caisse Sours on Debt?

Frederic Tomesco of Bloomberg reports, Caisse Sours on Debt With Yields at Record Lows:

Caisse de Depot et Placement du Quebec, Canada’s second-largest pension fund manager, is losing its enthusiasm for bonds with yields close to record lows.

“Fixed income isn’t what it used to be,” Chief Executive Officer Michael Sabia, said yesterday in an interview at Bloomberg headquarters in New York. The manager of about C$215 billion ($190 billion) in assets anticipates reducing its holdings in bonds to around 30 percent over the next two years from about 35 percent, he said.

Bonds worldwide have returned 6.3 percent this year, the most since 2002, according to the $46 trillion of debt securities included in the Bank of America Merrill Lynch Global Broad Market Index. The rally, prompted by central banks in the U.S., Europe and Japan keeping borrowing costs close to record lows to spur growth, pushed average yields globally to a record-low 1.51 percent last month.

Sabia said he may reallocate sovereign debt that included C$15.7 billion of federal government bonds, C$14 billion of Quebec government debt, C$712 million of U.S. government debt and C$2 billion of other types of sovereign bonds at the end of last year. As Quebec’s largest institutional investor, Montreal-based Caisse has traditionally been the main buyer of bonds issued by the provincial government -- a situation that’s unlikely to change.

Lower Exposure

Canada Pension Plan Investment Board is the country’s biggest public pension manager, with net assets of C$234.4 billion as of Sept. 30.

“There are a lot of sovereigns in our portfolio,” Sabia said. “The balance between sovereigns and some other forms of debt, private debt, corporate debt, some real estate debt -- we may want to increase some of that and lower the sovereign exposure. That’s a way of leaving the fixed income in place, but doing a little better from a returns perspective.”

Sabia didn’t specify which sovereign bonds the Caisse would look to sell. At the end of last year, the Caisse held about C$19.7 billion of corporate bonds, including C$13.2 billion of Canadian company debt.

Lowering exposure to government bonds is part of a Caisse strategy to reduce the volatility associated with public markets. Sabia said last year the Caisse was planning to add as much as C$12 billion in “less liquid” assets such as infrastructure and real estate over two years.

Capital markets and central banks have developed an increased sensitivity toward each other since the global financial crisis of 2008, he said. That “co-dependency” may persist in 2015 and 2016, until the relationship between central banks and the capital markets normalizes, according to the 61-year-old CEO.

‘Market Turbulence’

Federal Reserve Chair Janet Yellen has said “she was going to look through the market turbulence -- if the market had a tantrum, she was going to look through the tantrum,” Sabia said. “I think they are trying to find this goldilocks solution where they can move interest rates slowly and keep everybody kind of OK. I’m not sure that’s doable, because I don’t think the markets have taken on board how fragile the situation is. That’s why I think 2015 and 2016 are going to be rock ’n’ roll.”

More than half of economists surveyed by Bloomberg from Nov. 12-14 said improvements in the labor market would prompt the Fed to raise rates in mid-2015. The Bank of Canada is forecast to keep rates at 1 percent until the last three months of 2015. The U.S. central bank ended unprecedented economic stimulus known as quantitative easing in October with the world’s largest economy gathering momentum.

Liability Matching

Economic recovery in the U.S. “is not strong by postwar standards, but it’s not bad,” Sabia said. “The U.S economy is actually doing pretty well. If you were just looking at that, you would say that the Fed is going to have to worry about how close the economy is getting to full employment, and what kind of ramp-up on interest rates is going to be required to moderate that, so that they don’t get too far behind the curve in terms of managing inflationary pressures.”

The Caisse held C$69.2 billion of bonds, real estate debt and other short-term securities in 2013 -- a collection of assets that generated an investment loss of C$41 million. Bond markets worldwide fell 0.3 percent last year, Bank of America data show. Overall, the Caisse had investment income of C$22.8 billion last year.

“If you were just making a pure returns-based decision, you would take that 35 percent down pretty sharply,” Sabia said, referring to the Caisse’s bond holdings. “Fixed income has other attributes. In terms of matching liabilities with the people whose assets we manage, that’s a reason not to take it down as sharply.”

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I discussed this latest news item with Brian Romanchuk, a former quantitative analyst at the Caisse's fixed income group who now consults and writes an excellent blog, Bond Economics. Brian shared this with me:

The premise of the article seems misleading. The issue is that they believe that other asset classes, especially illiquid stuff, can do better. Given the low interest rates on government bonds, that is not a high hurdle rate. In other words, if we avoid a risk asset apocalypse, those assets will outperform government bonds. I find it hard to argue against that.

Bonds are vulnerable versus cash in a rate hike cycle, but the potential losses are a fraction of the uncertainty in the valuation of things like real estate. But editors love stories that are bearish on government bonds. Even though we have been in a bond bull market for 30 years, I would be hard placed to remember an article with the headline "Expert says government bonds to outperform cash next year".

I also asked him: "What if deflation settles in Europe and comes to America, do you still think bonds will underperform illiquid asset classes?". He replied:

A mild deflation should not be that bad for risk assets; bonds would give positive returns. It would just mean that the current environment continues longer.

The real risk is a recession; it should not be as traumatic as 2008, but it would probably result in a reversal for risk assets.

Brian is one of the smartest and nicest people I ever worked with (worked with him at BCA Research and the Caisse). He reads incessantly and reviews many books. For a PhD in electrical engineering, he has a firm grasp of economic history and theory and is well read on Keynes, the monetarists and Hyman Minsky. I don't plug his blog as often as I should but always read his comments and think extremely highly of him (the financial industry needs more Brian Romanchucks and less weasels).

And he is right, all these experts bearish on bonds have been dead wrong for years. More worrisome, far too many investors are underestimating the risk of deflation spreading throughout the world and what this means for risk assets going forward. In my opinion, there is a reason why central banks are panicking, they fear that no matter what they do, they will lose the titanic battle over deflation.

And if they do lose this titanic battle, the only thing that will save your portfolio from huge losses is good old government bonds, which is why I wouldn't be surprised if U.S. bonds keep rallying despite historic low yields.

Interestingly, my contacts in the hedge fund community tell me a lot of macro funds got their calls on stocks and currencies right -- going long the S&P and shorting the yen and euro -- but got killed on their bearish view on bonds which is why many of them are underperforming in 2014.

Now, getting back to the article above, Michael Sabia isn't exactly writing bonds off. Far from it. He worries about how the Fed will raise rates slowly to maintain the Goldilocks economy but he rightly notes that from an asset-liability point of view, bonds play a significant role.

Given my views on deflation, I'm not as worried as Michael about bonds and how well they will continue to perform going forward. He's right, things will be "rock 'n roll" in the next two years but not because the Fed will be hiking up rates and bonds will crumble. It will be because inflation expectations will sink further as more and more investors come to grips with deflation coming to America and fear sets in as they perceive the Fed has fallen behind the deflation, not inflation, curve.

This is why I openly worry about pension funds flocking to riskier investments at this point and time. If a severe bout of deflation does engulf the global economy, taking on too much illiquidity risk can come back to haunt them.

Below, the Caisse's CEO Michael Sabia discusses the markets and his investment ideas on Bloomberg's ”Market Makers.” This is an excellent interview so take the time to listen to his comments on why markets are too focused on the short-term, why the Caisse is moving more into illiquid investments and why despite having 1% invested in hedge funds, there are advantages to investing with the best alpha managers around the world (basically knowledge leverage).

As a background to this interview, read Brian Romanchuk's recent comment, Abenomics - Mission Accomplished?, and my comment on life after benchmarks. I also urge you to read my last comment on the Caisse's warning on Canada's energy policy and why their focus on pipelines and investments in Mexico has significant risks.

I also embedded a CNBC clip discussing whether we're in the midst of a credit boom and how much further equities can run, with Jeffrey Saut, Raymond James, and Brian Reynolds, Rosenblatt Securities.

As I've warned, the real risk in the stock market is a melt-up, not a meltdown, but choose your stocks and sectors right before taking the plunge and use the information I provide you on top funds' quarterly activity wisely, keeping in mind that in these crazy markets, even the best of the best get it wrong.

Lastly, I embedded a CBS 60 Minutes report on America's neglected infrastructure. There is no question in my mind that U.S. politicians need to increase the gas tax and invest more in their crumbling infrastructure. Watch this report, it's a real eye-opener.