A revitalised approach that prioritises active management, value-add strategies and the hunt for alpha in CalPERS $168.6 billion global fixed income portfolio is starting to pay off. Speaking during the pension fund’s annual review of the asset class, which accounts for around 30 per cent of the $556 billion portfolio, investment staff said fixed income has garnered around $600 million in value-add over the last five years despite a honed-down team.
The wholly active and internally managed allocation to investment-grade corporate debt has been one of the star performers amongst the five strategy seams in the portfolio that also spans sovereign bonds, high-yield, mortgage-backed securities and emerging market debt.
Investment-grade credit has posted a one-year absolute return of 6.5 per cent, amounting to an excess return of 31 basis points on an active basis, equivalent to $100 million in value-add driven by strong income from elevated bond yields.
Active value has come from overweighting and underweighting strong and weak companies in the index in an approach that came into its own during April’s Liberation Day volatility, when the team added risk at attractive valuations as the dispersion between corporate winners and losers widened.
Moreover, the performance of investment-grade credit particularly stands out given CalPERS has been underweight and defensively positioned the entire fiscal year, investment manager Brian Parks told the board.
ESG integration within investment-grade fixed income has also given the allocation a valuable edge.
For example, CalPERS profited after fundamental ESG analysis drawn from sister teams in sustainability and governance led by Peter Cashion and Drew Hambly informed the belief that last year’s strike action at defence giant Boeing would end, and production at the company would get back on stream.
CalPERS positioned accordingly, overweighting the company on the basis that it would get compensated for governance risk and there was an advantage in adopting a larger position because Boeing’s bonds were “trading cheap.”
“Once we came to that conclusion, [Boeing] became overweight in the portfolio,” said Parks.
ESG analysis in investment-grade credit explores ESG scores and the relevance of any downgrades to CalPERS underwriting processes. Parks said the team are currently focused on about 15 companies. Engagement is led by the CalPERS corporate governance team, which acts on behalf of both the credit and equity teams.
High-yield strategy in action
A similar active strategy of positive security selection also boosted returns in emerging market debt, an allocation that CalPERS only began two and a half years ago. Since then, it has added around $240 million to performance in a strategy where expert external managers still play a central role. Only 10 per cent of the allocation is internally managed.
In another step change, the high yield allocation has shifted from mostly passive to mostly active. Like investment-grade, the approach paid off during this year’s April volatility. More recently, CalPERS seeded $2 billion to J.P. Morgan Asset Management’s active high-yield ETF, drawn from an existing high-yield mandate.
“This is the first active high yield ETF – they tend to be passive [but it] fits with our active high yield strategy [and] it ultimately adds the ability to capture volatility going forward in the world and we are looking for more active opportunities,” said board president Theresa Taylor.
Elsewhere, the allocation to mortgage-backed securities tapped alpha in active, relative value trades and by increasing exposure to securitised credit.
Concerns about Fed independence
CalPERS staff said the current fixed income market is characterised by attractive yields. However, because credit spreads relative to US treasuries are historically “on the richer side,” the investor has a cautious outlook.
“We take more risk when assets are cheap – that may not be today,” said managing investment director Arnie Phillips, who also reflected on looming risks.
Federal Reserve independence and the size of the US budget deficit are front of minds.
“A world that loses faith that the Federal Reserve is independent will have a potential impact on the portfolio,” he said.
He said that a large deficit comes with large sovereign issuance which can crowd out other forms of financing, and he warned that the government will have to pay more to sell its bonds.
In another alarm bell, CalPERS investment advisor also warned that history shows indebted governments often resort to printing money in a short-term strategy that specifically benefits assets with a limited supply.
Alignment with TPA
The fixed income allocation is beginning to shift in line with CalPERS’ progress towards a total portfolio approach (TPA) that requires cultural and structural changes as the investor puts more emphasis on total performance and team effort, rather than individual asset classes.
For example, cross asset class collaboration is visible in investment director Justin Scripps crossing the floor to temporarily join the private debt teams working in insurance-linked securities and investment grade corporates, blurring the lines between public and private fixed income.
Moreover, the fixed income team already closely collaborates with the CalPERS treasury team on liquidity and leverage strategies, pushing the envelope on cultural, and staff, development.
The board heard that TPA will likely lead to higher correlations between equity and credit risk in global fixed income, requiring monitoring in the overall portfolio construction process and leveraging the ability TPA gives to invest anywhere in the capital structure.
Chief investment officer Stephen Gilmore has formally recommended adopting TPA with a 75/25 equity-bond reference portfolio and a 400-basis-point active risk limit whereby management has the discretion to pursue value-add and risk-mitigating strategies. TPA will replace 11 different benchmarks with a single view to evaluate management decisions.
There will be no change to CalPERS’ 6.8 per cent discount rate.
If TPA is adopted at the November board meeting, the strategy will go live from July 2026. The months in between will be spent on priming governance, reporting and collaboration strategies ahead of the off.
The introduction of TPA has been supported by nine board education sessions so far.
