“When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbours get envious,” wrote Warren Buffett in his 2010 shareholder letter in one of his frequent criticisms of the strategy where investors borrow to invest more. “But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices.”
Buffet’s comments contrast with other investors who are equally convinced leverage provides a vital ingredient to their portfolios, either reducing risk by borrowing to invest more in low-risk assets and boost diversification, protecting their funding levels, or for a bolder cohort, allowing them to increase investments in risk assets.
Through the noise of protagonist assurances and critic warnings, one thing rings true. Against the backdrop of rising rates, market turmoil and pension funds’ ever-growing illiquid allocations, leverage is going to increasingly come under the spotlight.
Last year board members at CalPERS, America’s biggest pension fund, voted in favour of borrowing to invest an amount equivalent to 5 per cent of the fund’s value, around $25 billion, to help it meet its 6.8 per cent return target.
In the Netherlands, pension funds don’t lever their overall balance sheet but new laws being drawn up to support the country’s moves to a DC-based system are exploring how leverage could be applied between different lifecycle funds.
Canadian funds have been applying leverage for over a decade. The C$541.5 billion Canada Pension Plan Investments applies 22 per cent leverage to the portfolio, borrowing money to increase exposure to less risky assets and boost diversification without further increasing its already above average 85 per cent equity risk target. CPPI’s use of leverage leaves its risk tolerance unchanged, says Edwin Cass, chief investment officer at CPPI.
America’s State of Wisconsin Investment Board (SWIB) which manages $144 billion of state retirement and investment funds and has used leverage since 2010, approved an increase in the Core Fund leverage from 10 per cent to 15 per cent in its 2021 asset allocation in a strategy that involves reducing equity exposure by leveraging low-volatility assets like fixed income.
“The leverage helps reduce risk by supporting a higher allocation to lower risk fixed income securities and a lower allocation to equities at the same overall target return. This strategy is one part of our overall long-term strategy of greater diversification and risk control,” says Edwin Denson, executive director and CIO at SWIB. Elsewhere US funds like Texas Teachers introduced leverage in 2019.
In another approach, Sweden’s SEK849 billion ($90 billion) AP7 has a riskier strategy, borrowing up to 15 per cent of its portfolio value to allocate more to global equity.
“We can take on a bit of risk, and to get that additional risk we use leverage on our global equity exposure,” says chief investment officer Ingrid Albinsson. Sister fund AP1 has also been using leverage for a long time, motivated by diversification.
Other pension funds have a different approach. “Leverage can help increase fixed income exposure and reduce the total risk to a fund’s surplus,” explains Roman Kosarenko, senior director, pensions, at $2 billion listed Canadian corporate Loblaw Companies Limited who studies leverage use in pension funds. He says that once leverage is viewed through the lens of protecting the surplus – rather than focusing on asset returns – it is much better understood by pension funds.
“Every dollar of incremental returns you earn via leverage provides you with a surplus cushion to protect against a possible hit to your surplus, including from rising interest rates.”
Sources of finance
Over the years, Canadian funds’ expansion and sophistication in tapping leverage reflects how central the strategy has become with almost all Canada’s big funds running sizeable commercial paper programs and borrowing billions via the repo markets. CPPI issues commercial paper in the domestic, US and UK markets for terms out to 30 years. Elsewhere, it borrows in the repo market while around one third of its leverage comes through short selling derivative contracts.
The $227.7 billion Ontario Teachers’ Pension Plan has developed a sophisticated investment funding strategy designed to diversify the maturity, market-sources and cost of its borrowing run out of the Ontario Teachers’ Finance Trust (OTFT), set up in 2015 to sell debt to international institutional investors. Canadian funds have also jumped on green issuance as another source of finance, issuing around $6 billion of green debt to date.
Leverage strategies have been fuelled by low interest rates and rock bottom borrowing costs. Canadian pension funds with a AAA rating can borrow for peanuts, says Alex Beath, senior research analyst at CEM Benchmarking in Toronto who argues for them not to do so, is actually imprudent.
“In a low interest rate environment, not to consider how a fund might be able to use leverage is imprudent. It is so cheap to borrow, funds almost have to look at leverage as being part of a good fiduciary.”
Unlike Beath’s cheerleading however Malcolm Hamilton, senior fellow at the C.D. Howe Institute in Toronto, is a fierce critic of leverage. Still, he charts its origins from the same source. As interest rates dropped, real returns from bonds fell away. Pension funds found that increasing risk by leverage was a convenient way to meet their return objectives.
“What they’ve done is just as risky as reducing the bond allocation and increasing the allocation to public equity. Had interest rates not dropped, I suspect Canadian pension funds would have little leverage today.”
It means today’s changing macro picture of increasing interest rates and rising borrowing costs will put pressure on pension funds to ensure financing costs are adequately compensated with expected returns.
Investors using leverage and borrowing to invest by expanding their fixed income exposure in a rising rates environment, could end up buying into an overpriced asset that will steadily depreciate as rates rise. Today’s climate opens the door to operational unpredictability, making a fund’s liquidity profile and confidence in its decision makers crucial, says Kosarenko.
“Unexpected increases in interest rates devalue the bond holdings and substantially reduce the actual (as opposed to expected) rate of return on assets.”
It leads him to reflect that now might not be the time to embark on the strategy – and pension funds that have never used leverage may have missed the boat.
Pension funds that haven’t used fixed income leverage, missed years of opportunity to improve their surplus in an environment of secularly falling interest rates, he says.
“If CalPERS is just about to start using leverage, they’ve missed a lot. With interest rates about to go up, it’s probably not the best time to start using it,” says Kosarenko.
Pension funds that have never used leverage may have missed the boat.
Looking ahead he is also concerned with the proliferation of leverage strategies now offered to smaller pension funds via institutional pooled vehicles. These strategies are subject to more pronounced settlement impact, he warns. Leverage is best managed via separately managed, segregated, accounts which give essential operational flexibility which pooled funds, governed by fixed policies around rebalancing, lack.
“If there is a sharp rise in interest rates, pooled funds may still be forced to de-lever at a time bonds are temporarily cheap, selling out at prices they really don’t want to sell out at.”
Leverage depends on ample liquidity. Pension funds that use leverage need to have enough on hand to ensure interest rate payments on their borrowing on top of all the regular calls on their liquidity like paying benefits and cash on hand to meet capital calls. Getting a grip on liquidity was a fundamental pillar of CalPERS former CIO Ben Meng’s ambition to introduce leverage at the fund. Meng’s first step was developing a liquidity framework that identified the pension funds calls on liquidity as well as liquidity sources like dividends, turning assets to liquidity and borrowing capacity via repo markets.
At CPPI strategy is shaped around floors to its liquidity coverage ratios, below which the organisation is put at risk. Cass adds his priority is to target a level of liquidity that does more than simply allow the fund to meet its liabilities. He wants money on hand through cycles to re-up with private equity funds while the variation margin in derivative contracts requires capital on hand.
But things can go wrong for investors re-financing repo arrangements on a regular basis, warns Serguei Zernov, formerly of OMERS Capital who is now an independent investment manager and researcher based in Toronto.
Acute illiquidity in the short-term lending market on the eve of the pandemic in March 2020 caused the repo market to become suddenly illiquid, making it costly, or impossible, to roll positions. Now investors are watching how current stresses in global markets linked to the economic fallout of Russia’s invasion of Ukraine impact.
“Without other recourses to liquidity, pension funds could be forced to liquidate investments and close positions at the worst time,” says Zernov.
For Hamilton, a key concern is Canadian pension funds ever-growing illiquid allocations, difficult to sell in a hurry. A prolonged downturn like the 1970s could have a significant impact on levered pension funds with a focus on illiquid investments, he warns. CalPERS’ board is as familiar with the investment team’s argument for a larger private equity allocation as they are its support of leverage. Building out the current 8 per cent allocation to around 13 per cent is a critical part of the return seeking allocation and central to the new strategic allocation.
the importance of Governance
Leverage fills many investors with trepidation but it’s worth remembering it will already exist in many of their investments. For example, private equity allocations to LBO funds will be highly levered, says Beath.
Elsewhere he notes how pension funds got burnt in the GFC with highly leveraged real estate exposure.
“A year before the GFC, if you’d asked them how much leverage exposure they had, they would have said none,” he says.
“Hidden” leverage on top of new strategies makes the need for governance even more important. Zernov stresses the importance of centralising the strategy beyond just an asset class level, aggregating and reporting all leverage instruments at the total fund level.
“There needs to be a clear understanding by custodians and board members what kind of leverage is used, and if risk is consistent with objectives and risk profile of the plan.”
At CPPI layers of robust governance include a special committee that came into play to control capital going out the door and ensure liquidity levels through the 2020 crisis. It was stood down nine months later.
Still, Hamilton argues that even Canada’s professional boards with their finance backgrounds and familiarity with the strategy, have governance gaps. Many public Canadian pension plans offer members guaranteed benefits with no link to fund performance, he explains.
“Members may bear part, or none, of the risk while the public bears all, or most, of the risk depending on the plan.”
He says that because members don’t bear the risk, the funds feel they can take more risk, free from ultimate responsibility.
“From my perspective, we have a governance failure – the public bears most of the risk while the plan members receive the expected reward for risk taking. No one represents the public interest in the decision-making process.”
No strategy, leverage included, works under all conditions, concludes Kosarenko.
“Pension funds using leverage should monitor market conditions and have policies on scaling down the leverage if there is a rising likelihood of deteriorating conditions.”