Robert Pemberton says to focus on the work portfolio managers do before making an investment decision.
In fact, the head of fixed income at TD Asset Management in Toronto says it’s important to challenge a manager’s due diligence, double-check a team’s research capacity and confirm their work is consistent.
All this helps ensure investors are getting a return that’s in line with the risks they’re taking with their money.
“We’ve seen an increase in due diligence, both from the consulting community and individual investors, and we welcome it,” says Pemberton, who joined TD in 2000 and has more than 25 years of experience trading fixed income. He oversees $100 billion in fixed-income investments for institutional clients and $40 billion for retail clients across more than two-dozen funds. “This was the absolute right place for me to end up,” he says, because the job makes the most of his natural curiosity and love of math.
“Not only do you need to know everything about the companies you’re investing in, as all equities investors do, but you also have to know all the math of yield curves and credit curves, and the implications of monetary policy globally.” Here’s how Pemberton invests in both passive and active fixed-income strategies.
Q: How do you manage your passive fixed-income investments?
A:We take a defined benchmark and use a stratified sampling to provide clients with a fund that has a similar structure and return. Stratified sampling means taking a high portion of the benchmark to deliver a benchmark-like return and structure. The FTSE TMX Canadian Series Bond Universe has approximately 1,200 securities, so buying the exact proportion of every one of those isn’t something any investor would be capable of. What we do is look at those 1,200 and [determine] how we can best deliver index-like characteristics and returns, with tight tracking, without owning all 1,200.
It could be that clients want components of the index, such as separate specific credit, or specific provincial or other government risks. There’s a sub-index that’s all government, a sub-index that’s all provincial, and a sub-index that’s all corporate. As an asset manager, we can break down all of those sub-components and manage a pool of assets specifically to the characteristics of those sub-components. Some investors would like passive investment of their government bonds and active investment of their corporate securities, for example.
Q: How do you manage your active fixed-income portfolio?
A: We [use] three principles:
- Fundamental independent research.
- Deconstructing both the yield and credit curves in order to understand where risk is being appropriately priced, and how to take advantage of it.
- Portfolio construction.
We meet with management teams, issuers, origination teams and syndication teams. Origination teams are people at the dealers who are thinking about talking to an issuer [about a deal]. A syndication team is the group at the dealer that already has a mandate to raise capital.
When we sit down with management, both our fixed-income and equity teams are at the table. [This] ensures that we consistently understand and have a view of what a management team is going to do for both sides of the capital structure. [This includes] returning capital to equity owners, while at the same time maintaining the appropriate leverage or capital structure in order to meet the cash flow needs required to satisfy fixed-income investors. For instance, we ensure management has flexibility in its capital expenditure program. Most of the details we’re interested in won’t be in the headline numbers of a company’s financial statements, but in the financial notes. [It could be] off-balance-sheet structures, such as capital leases. Do they get put back on the balance sheet or not? Or capital expenses versus business expenses. [Or] the depreciation methodologies that they use—do they change frequently? What has changed within the business that would require switching accounting methodologies on a more frequent basis? Or has the industry itself seen some regulations come through that require it? When looking at headline numbers, don’t just look at the numbers without context. Consider: How is a company’s balance sheet or income statement changing over time? Why is it changing over time? What are the implications? We want to be able to ensure that a company will deliver the cash flows required to pay their coupons in a timely manner, and their principal at maturity.
The financial crisis was an opportune time because we’d done so much work ahead of time. We had avoided the pitfalls of third-party asset-backed commercial paper because of the lack of transparency. We also avoided the U.S. financial sector because of the amount of leverage and lack of transparency about how that leverage was being used. The types of things that come up as warning flags to us [include] if there’s a lack of transparency or excess leverage, or [they’re] entering into a new market where [they] have no previous expertise. Are [they] a prime candidate for an M&A or LBO [leveraged buy-out]? Those are the things that we’re always assessing.
Q: What’s different about investing for an endowment compared to a pension?
A: It’s their risk appetites and how endowment models work. Take the model used by East Coast universities, which has been a popular one. Their risk tolerances have grown over time because they have to demand more from all of their assets to deliver on promises the endowment foundations make—whether it’s capital projects or scholarships. Endowments, though they have long time horizons, also have operating and capital budgets to think about. Time horizons are dependent on the endowment, but they tend to have a continuous run rate on an annual basis. For capital projects, there are milestone payments as they build a new building or put equipment in. So we need to think about how to fund those. It may be investment-grade corporate bonds, or high-yield bonds, or emerging market bonds.
For each of those securities, my view is focused [on] valuation, compensation for unit of risk taken and opportunity. A high-quality corporate bond in the 10-year sector in Canada yields an investor twice what a Government of Canada bond does. Government of Canada bond yields right now are [about] 1.4%, and you can get between 2.5% and 3% in a high-quality Canadian corporate bond.
Pensions have a liability structure, and we find more pensions are moving away from standard benchmarked outcomes and looking at liability outcomes. How one pension plan’s liabilities look compared to another is different. Why should the benchmark they choose be the same?
Most Canadian pensions use the FTSE TMX Canadian Series Long Term Bond Index, but we’re seeing more pension clients, their consultants and consulting actuaries choosing liability-like structures for their benchmarks. Based on actuarial assumptions such as longevity, final earnings capacity and inflation, you can derive the net present value of every year from now until the pension plan may have to wind up. That will derive a specific set of cash flows that are required for that pension plan, and how you might structure [the portfolio] to best meet those.
The outcome is those pension plans [can see] the appropriate level of risk as they move forward. It’s about reducing the volatility of the assets of the plan, relative to the liabilities.
Q: Are you predicting we’ll have low interest rates for a while?
A: Yes. If we look at interest rates back over the last 200 or 300 years, we see that when debt finances economies, and a debt bubble occurs, interest rates for the next 10 to 15 years thereafter are lower. Even if interest rates in Canada on a 10-year government bond went from 1.5% to 2.5% over the next three to five years, would those interest rates be considered high? I don’t really see that as being a high-interest-rate environment.
Q: With low yields on many bonds, how do you ensure your clients are getting sufficient returns?
A: Investors, over the past 30-plus years since we saw interest rates peak in 1981, have enjoyed equity-like returns with fixed-income volatility. Certain segments of the market have expectations in the current environment that may not be achievable, given where we are in the marketplace.
In the current environment, given the absolute low level of interest rates and the perception that those rates are going to remain lower for a longer period, we prefer to own the bonds of high-quality corporations than own sovereign debt. We don’t believe that yields—whether [in] Canada, the U.S., Europe or emerging markets—at the sovereign level are going to provide investors with a real return over time.
|Top ten holdings for TD Canadian Bond Fund-A|
|Security||Percent of portfolio|
|Government of Canada 5% 01-Jun-2037||5.4%|
|Government of Canada 4% 01-Jun-2041||3.9 %|
|Province of Ontario 5.6% 02-Jun-2035||2.3%|
|Province of Ontario Residual 2.66% due 6-June-2017||2%|
|Toronto Dominion Bank, Callable 4.779% due 14-Dec-2105||1.8%|
|B.C. Province 4.3% 18-Jun-2042||1.7%|
|Government of Canada 5.75% 1-Jun-2033||1.6%|
|Government of Canada 3.5% 1-Jun-2020||1.5%|
|Government of Canada 2.75% 1-Jun-2022||1.4%|
|Province of Ontario 6.2% 2-Jun-2031||1.1%|
Holdings as of May 19, 2015 Source: TD Asset Management