Get Ready for Rising Rates, Uncharted Territory

In just a few weeks we will be gathering for the 3rd annual Challenge of Change Forum in Vancouver (October 13th to 15th). A big part of the Canadian Leadership Congress’ success is our Advisory Board – and Marlene Puffer, CEO, CN Investment Division, has been with us from the start. Marlene will be wearing a couple of hats at the event, helping us to celebrate the career of Jim Keohane and also speaking on our panel on investing in Asia. We connected with Marlene recently to get her views on risks in the market, leadership in changing times, and why the Canadian Leadership Congress is important to her.

With inflation and a possible rate hike in the cards, what are the risks in the fixed income space and how should asset owners be addressing them? Where can they turn for yield?

Obviously the risk is that interest rates rise materially – and that’s not fun! We are now in uncharted territory and there is a risk that the markets will overreact to every piece of information that comes out. It’s the taper tantrum concern. Somehow the European Central Bank is finding a fine line to tread to manage market expectations. The big open question is, can the Fed do the same? Can it communicate in such a way that markets will react with gradual interest rate movements rather than spikes and peaks and valleys? I think it’s going to be very difficult for the Fed to do that so I would expect that spikes, peaks and valleys will be the reality.

So where does that leave pension funds?

It’s difficult when you’re in an asset-liability framework and you have quite a lot of long-term bonds in your portfolio. Because we are going to suffer the mark-to-market on those – that makes our returns look weak or even negative on the total fund if the market movements are sufficiently large. Most plans are not fully hedged – so when interest rates rise, the first step is that the funded status improves. That part is good. However, the low or even negative fund returns are painful. The question is, are funds going to shift quickly enough to add additional fixed income exposure – duration – and, if so, at what interest rate level? It’s the big question right now. It’s painful to be short duration for extended periods in anticipation of the move, so timing is key.

What can they do to temper the pain of rates as they rise? Most pension funds have been using more active management of their asset-liability management portfolio. So whatever their fixed income allocation is, there’s more active management effort to add value. It can be tough to reliably generate alpha through active trading within the Canadian fixed income markets, so you can use a variety of other tools, which is what we’re doing.

A key part of our approach has been to overlay absolute return over fixed income. Another big piece of the puzzle is also private debt markets, where the duration exposure is almost none – the base is a floating rate. That is obviously better when interest rates are on the rise and the exposure to credit spreads and the illiquidity premium is attractive. Emerging market debt is another area of opportunity.

Pension organizations have changed how they invest dramatically over the last 10 to 15 years. How has that impacted their need for talent?

We need outside the box thinking first and foremost. And we need teams that are able to communicate well with each other. They need to be open to other ideas and to hone them into new and creative approaches. It’s not enough anymore to have skilled, siloed specialists. We need skilled specialists and others who can stimulate out of box thinking. Also, you need to cross-pollinate across teams to encourage the coordination of value-adding strategies that may include derivatives, complex structures, and currency exposure.

Overlays, for example, are complicated. If you put an overlay on and you don’t pay close attention to the funding leg, then you may leave basis points on the table.

It can be challenging to structure an effective cross-disciplinary team that pays attention to how you’re using your equity portfolio or your fixed income portfolio for funding at any particular point in time. For example, how do you optimize that and optimize the use of derivatives related to that to minimize the cost of funding, minimize the volatility of your margin calls, all while keeping close tabs on liquidity and resilience to extreme events?

We have talked for 20 years about overlays and there are reasons why they haven’t been done that much by smaller plans or they’ve been outsourced. Inevitably there have been missing details on implementation and coordination to try and minimize cost associated while gaining benefits of overlay strategies. Teams must understand all the subtleties of the strategies and communicate mandates processes and procedures clearly.

This is hard to do. It takes leadership and ability to ensure that oversight is tight and to coordinate the front and back office. You also need your board on side which requires detailed communication about the benefits and the operational risks and controls.

Lots of doom and gloom messages out there right now — what’s one thing that makes you optimistic at the moment?

There are a lot of things to choose from. Probably the most important thing is that people are sharing their vaccination status, which is allowing more people to be more comfortable meeting in person. That is the game changer for shifting to a new version of normal both in our personal lives and in business. This is a key piece of our office reintegration plan, which will incorporate more flexibility than prior to the pandemic.

The market has continued to be optimistic throughout all this – can policymakers walk that fine line to keep markets from quickly becoming pessimistic? A massive flow of capital has been injected into every economy on the planet – if the taps are turned off too sharply, then that optimism in the market could quickly disappear. But that combination of vaccination status and policymakers continuing to keep just enough liquidity flowing in…I think it’s possible we can do this. Whatever happens related to vaccines and central bank actions, based on our experience throughout 2020, I’m optimistic that our team will read and react effectively.

You’re coming to Challenge of Change in a few weeks – why is CLC important especially right now?

Challenge of Change is the most important Canadian event I go to. I make the effort and I’m a big supporter because the right people are in the room and the right conversations are being stimulated. There’s a very thoughtful approach to the topics — it ensures they are meaningful to our day-to-day decision-making while addressing the longer-term strategic thinking we need to do.

My favourite part is the Congressional Huddles. They are what stimulate discussion that then carries on to other windows of opportunity to talk to each other. It’s like throwing a ball into the court and letting people keep bouncing it around.

For those interested in joining Marlene in-person in Vancouver, we can add you to a waiting list available for the Challenge of Change Forum from October 13-15.

Contact CLC Co-CEO, Joanne Boccia, today.