Pew Charitable Trusts State Pension Review - No good news here

State pensions have changed their portfolio composition during the last ten years to increase their allocations to alternative investments, yet this adjustment has not helped them reach their targeted returns. This gloomy story was presented by the Pew Charitable Trusts State Public Pension Funds' Practices and Performance Report.  

Fixed income allocations have stayed stable, but there has been a switch from equities to alternative investments, yet this has not translated to better absolute returns. The alternative investments were supposed to give higher equity-like returns, but may have behaved more like enhanced fixed income. Perhaps the ideal return profile was never a true possibility. The return gap for many states has been significant. The only way the gap would have been closed would have been to hold large equity beta bets. In hindsight this may seem obvious, but in reality it was a risk states were unwilling to take. The half step was to increase alternative investments.  

Unrealistic returns expectations could be the reason for the funding gap, but the story is clear. States have a problem. They did not generate the returns actuarially expected and expected returns in a low fixed income and growth environment suggest that the gap will not be closed in the future.  As the retirement pool increases, more funds will be needed for pay-outs and not available for future retirees. While some states have done a better job, no state has been able to exceed their return targets for the ten year period analyzed. 

States are aware of the problem and have lowered their funding return expectations, but these numbers are still high when you consider current yields and what may be reasonable equity return assumptions.

The challenge and burden for alternative investing is whether strategies can be employed to close this funding gap and meet some absolute return targets. With over $3+ trillion invested, all state pension funds may not be able to succeed at raising returns without taking greater risks. There just may be too much money chasing limited return opportunities. Everyone cannot have special investments. Nevertheless, each state has to try and find a mix that will lower risk and boost returns.

Corporate debt growth has exploded - The added macro shock sensitivity creates real risks

There is no question that the explosion of corporate debt has caught the attention of many investors. This debt growth has been especially strong for BBB-rated companies which on the cusp between investment grade and high yield.  Yet, like the boy who cries wolf or the doomsayer who is predicting the end of the world, warnings of a credit crisis do not seem to have affected investor activity. Corporate spreads are still tight and the reach for yield has continued almost unabated. Investors have not been given reasons to care about this debt issue today and have pushed any risks into the future. 

The potential risk for credit is always front and center with any discussions about a new financial crisis but usually the conversation stops there. There is less discussion on what is going on under the hood with respect to credit markets. A recent Bloomberg story highlighted some of the issues that should frighten any investor, see "A $1trillion dollar powder keg threatens the corporate bond market". This article outlines one scary feature of the added debt; the junk bond leverage for some investment grade firms. This article suggests that rating agencies are not doing their job. We have seen this story before with rating agencies and structured finance. The story implies that when the next macro shock occurs, there are some very large issuers who will see significant declines. 

The size of debt may not increase the likelihood of a negative shock. The increase in debt changes the sensitivity to any credit or macro shock. The increased shock sensitivity is what should be feared. A simple walk through of some scenarios shows why investors should be concerned. A lot of this sensitivity spills over to equity markets, which will have a macro wealth effect.

The refinance effect - Much of this corporate debt will have to be refined in an environment that will have higher interest rates; consequently, the cost on firms will increase and push down earnings. Funds will have to be used to delever, or marginal companies may not be finance this new debt. Not a problem today but the earnings sensitivity to rates will increase in the future.  

The index cram down effect - With much of the debt being financed by BBB-rated firms, any downgrade will have costs for investors as portfolios will have to be restructured. Spreads will widen on the pushdown of debt that was investment grade but dropped to high yield indices. For some investors who have yield restrictions, there will have to be a sale of the debt which will have a flow effect.

The optionality (Merton) effect - Given the Merton liability model of the firm and optionality, equity is viewed as a call option on the value of the firm and debt is a short put option. An increase in leverage makes debt more sensitive to any increase in equity volatility. An equity shock will impact debt holders.

The leveraged equity effect - Leverage will increase the riskiness of the firm, which will impact stocks, if there is any macro shock given the costs of restructuring and bankruptcy. Marginal lending will not be available to these firms.

The covenant effect - The demand for debt allowed a reduction in covenant protections. The impact of covenant-lite bonds is straightforward. The covenants add warnings, early protections, and restrictions that all help bondholders. If these are gone, risk increases. While some empirical work suggests that there is no effect from fewer covenants. The testing has not been under stress scenarios. Regulators have asked banks to restrict covenant-lite lending, but the practice continues.

The shadow banking effect - The demand for credit has outstripped the supply available from banks, so hedge funds and private equity have moved into the lending space. The impact of these new players is unknown. My banking experience has always told me that one bank loan chews up the time and resources associated with underwriting many good loans. 

The overall effect of more leverage is that the next time there is a macro shock both equity and debt will be more sensitive to a downturn. Investors may not feel any impact today, but when it comes the effect on markets will demonstrable.

The Alternative Risk Premium Matrix - A good way to jumpstart a portfolio

An alternative risk premium (ARP) matrix is an effective way to start any portfolio construction exercise. A matrix divides risk premia through two criteria, asset class and style. We think in terms of a 5x5 style/asset class matrix. The asset classes include: equities, rates, credit, commodities and currencies. These asset classes have inherent differences that make them unique even when looking through an alternative risk premia lens. For alternative risk premia we include: value, carry, momentum/trend, volatility, and special situations. These styles are been well-defined and identify risk premia that can be exploited through forming long/short portfolios and are actively traded and structured through the bank swap market. 

The matrix can create a broadly diversified portfolio across style risk premia found for each asset class. Full diversification would include a range of styles across a broad set of asset classes. An allocation can be made to each of 25 buckets in a 5x5 construct. However, an asset class specific portfolio would diversify across styles and a style specific portfolio will invest that style across all asset classes. 

Investors can think in terms of specific asset classes or styles to form different portfolio combinations. For example, in the currency asset class, there are well-defined risk premia that include: value as defined through purchasing power parity; carry through long/short portfolios based on interest differentials; momentum and trend premia based on past price action; volatility premia based on option implied versus realized volatility; and special situations associated with curve plays and liquidity. 

A similar matrix exercise can diversify a given risk premia style across asset classes. For example, a portfolio focused on momentum and trend could include allocations in each of the five asset classes identified. 

Correlation or cluster analysis can be used to find risk premia, which are uncorrelated, in order to form a diversified portfolio but a risk premia matrix can serve as theoretical basis for portfolio construction. This approach is especially helpful as the set of risk premia expands.  

Nevertheless, the risk premia for specific styles and asset class across a number of bank swap providers may not be all the same. Banks which offer risk premia through swaps may create different portfolios to represent a given risk premia. Within a given style and asset class, there can be a cluster of banks that offer different risk premia products. Some may be closely correlated while other can be very different. For example, one bank may not define the alternative risk premia for rates carry the same way as another bank. Additionally, the markets included in the swap index for a given style/asset class combination may differ across bank providers. These swap differences for a specific ARP is a source of competition and differentiation across banks. 

The portfolio matrix and structures should account for the differences across ARP products within a styles and asset class bucket. This adds bank specific differences to our portfolio matrix but it does not change the overall story. This framework, albeit simple, provides a useful tool for creating a scaffold for forming a portfolio structure.

Forward Guidance - When in Doubt, Expect a Cautious Fed

President Trump mused that it would be "crazy" for the Fed to raise rates in December, but his comments miss the point on how the Fed is operating. The continued themes through Fed forward guidance are caution and flexibility. Investors are looking for certainty about the policy path, but the Fed is only going to give fuzzy guidance. Policy will be adjusted slowly so as to not make a mistake. There will be no rules that will bind behavior. When in doubt, do not change from the status quo. We are still living a Yellen Fed world.

This was clearly stated a year ago at one of former Fed Chairman Yellen's speech at an ECB conference.

“In my experience, market participants are very interested in knowing what the path of policy will be and when changes will be made either in asset purchases or in the policy path. And that’s something that central banks are loath to provide."

 “Obviously there’s inherent uncertainty about the outlook for the economy and so the committee’s expectations for appropriate policy evolve in time and in line with the outlook. When that happens my experience is that market participants often feel they have been misled,” 

Names and faces may change, but the behavior of the Fed usually does not. If you are expecting something to change with a new Fed Chairman, you will be disappointed. See Chairman Powell's comments at the Jackson Hole conference. He is comfortable with a cautious Fed based on the old Brainard principle that when uncertain about the effects of policy move more conservatively.

"In retrospect, it may seem odd that it took great fortitude to defend “let’s wait one more meeting,” given that inflation was low and falling. Conventional wisdom at the time, however, still urged policymakers to respond preemptively to inflation risk even when that risk was gleaned mainly from hazy, real-time assessments of the stars."

However what is different is that some of the underlying guideposts such as r-star have been deemphasized.   Do not expect any short-term reaction to changes in macro data. Do not expect a reaction to the recent volatility in equity and fixed income markets. While there may be more focus on what the Fed might do, investors should work under a prior of no change from current policy. When in doubt, fade Fed action especially if the markets respond to data still in a broad range of tolerance.

Fuzzy criteria on what data will drive policy given it may be noisy, fuzzy models on what is the neutral rate of interest, and a fuzzy reaction function that does not bind the Fed to inflation, growth, or asset market behavior is still the order of the day.