After missing the strong rally in the US high yield debt market, the $201.3 billion CalPERS’ global fixed income program, which manages about a quarter of the fund’s assets, has extended its mandates with external managers and will continue actively managing its US debt portfolio internally.
PIMCO and Nomura, the two managers appointed by CalPERS to help run domestic high yield portfolios, missed the sharp rebound in the sector after it declined precipitously as the credit cycle worsened in 2008. The rally was fuelled by the performance of companies “with the very worst prospects”, to which CalPERS held no exposure, according to a submission by asset consultant Wilshire Associates to the fund’s annual review of the $27 billion GFI program.
“Unfortunately, the subsection of the high yield market which performed best was the lowest rated companies, with CCC bonds and lower returning 100 per cent or better in many cases since the market bottom,” Wilshire writes. CalPERS held no exposure to these companies.”
The 12 months from September 2008 was a “tale of two halves” for the GFI program, as it recovered from six months of losses to post strong returns from April to September, CalPERS states.
The US debt portfolio, which, apart from some high yield investments is managed internally, posted 17.18 per cent against the 13.86 per cent gain by the fund’s customised domestic fixed income index. The international portfolio, which consists of allocations to five external managers, put up 18.46 per cent against 15.71 per cent gained by the benchmark, a blend of the Barclays Long Liabilities and International Fixed Income indexes. Its currency overlay added 0.51 per cent.
Wilshire Associates recently states the fund’s gross domestic fixed income performance was similar to the median manager’s. However in its review, CalPERS’ found its net return was 29 basis points above the median.
Since its inception in 1986, the fund’s internal US fixed income team has returned an average annual alpha of +38 basis points, at an annual cost of 1.2 basis points. The internal team manages 98 per cent of assets in the program.
CalPERS’ international fixed income allocations were first made in 1989, but were shifted into the global program in 2001. Since then, it has delivered +15 basis points of alpha. In 2008, the total cost of its external management arrangements was 17 basis points, and the full cost of the GFI program’s nine external mandates is 30 basis points.
Despite these costs, the investment committee resolved to extend the mandates with all external managers, which total $4.16 billion, by one year.
Wilshire recommended maintaining the mandates with all external managers, primarily because all five international credit managers profited from the rebound.
“All managers have had a fairly high correlation to the index over time, with no three-year rolling period for any manager less than 0.78. In almost all periods, all managers have generally had a correlation to the index of 0.9 or higher for their absolute returns,” the consultant states.
CalPERS’ also chose to continue active management of US fixed income because the long-term strategy has “succeeded” throughout economic cycles. But the recent surge in performance now requires the fund to sell $8 billion from the portfolio in the next 12 months to meet an asset allocation target of 20 per cent. After cashflow, GFI is the second largest source of liquidity for CalPERS.
This brings the conflict between the core purposes of the GFI program – investment diversification and liquidity provision – to the fore. CalPERS has found that investing in GFI to generate alpha and provide diversification created a “conundrum” because fixed income and equity markets were reasonably correlated, reducing the diversification benefit, and riskier credit strategies required liquidity to survive tough times, curbing the ability of the program to rebalance equity portfolios and help meet capital calls for the fund’s private market program.
CalPERS’ has calculated that its US fixed income portfolio held a relatively high alpha correlation with the equity market, generating a correlation coefficient of 0.38, cutting the diversification benefit. And during tough markets, most fixed income strategies aiming to capture alpha, such as investment grade credit and high yield debt, require higher levels of total fund liquidity so they are not abandoned, limiting the liquidity on standby for declining equity portfolios. In addition, CalPERS’ extensive private market program can add to these liquidity pressures, since uncommitted capital for private market assets “is effectively a call option” requiring greater total fund liquidity.
The GFI program accounts for 24 per cent of the fund’s assets, and allocates to a range of credit instruments: vanilla debt, such as global government bonds; riskier credit, including corporate, mortgage and structured credit; and opportunistic investments, such as life settlements and high yield.
In addition to helping to rebalance equity portfolios and meet private market capital calls, its excess liquidity also sustains ancillary programs, such as US fixed income, securities lending, credit enhancement, asset-based lending and a $10 billion currency overlay.
