The elevated interest rate landscape has been a boon for pension plans, but the picture isn't uniformly rosy, says Third Eye Capital CEO
In its October 2023 monetary policy meeting, the Bank of Canada (BoC) held its overnight rate steady at five per cent. This move, coupled with the backdrop of five per cent year-over-year wage growth and a three-month annualized underlying inflation rate of 3.5 per cent, hardly came as a shock. In the tail end of last year, BoC signaled a willingness to further tighten if inflationary pressures persist, fueling a ‘higher for longer’ narrative that has catapulted the Canadian 10-year yield to its highest level since 2007.
For pension funds, this elevated interest rate landscape has been a boon, considerably diminishing the actuarial liabilities associated with future retirement benefits. The Aon Pension Risk Tracker reports that corporate defined benefit (DB) pension plans within the S&P/TSX Composite Index now boast their strongest funded status since data tracking began in December 2012.
However, the picture isn't uniformly rosy. Higher interest rates and inflation have lifted the hurdle rate – the return required to maintain current funded ratios. Furthermore, unless plan sponsors have frozen or shut down their DB plans, burgeoning benefits and service costs remain an obligation. The situation is further compounded by recent setbacks in investment returns; in 2022, Canadian DB plans posted a median annual loss of 10.3 per cent, the most dismal performance since the 2008 financial crisis, according to an RBC Investor & Treasury Services survey.
Pensions face an uphill task
This presents a dilemma. With dwindling investable assets to cover fixed cash payments, pension funds face the uphill task of earning sufficient returns to maintain their funded status. With fewer assets to cover the same outgoing cash commitments, generating sufficient returns becomes a pressing concern. This exigency sharpens the focus on asset allocation, particularly as traditional asset classes falter. Plans that are either underfunded or have longer horizons could profit from a greater tilt toward illiquid private market assets, given their superior upside and diversification benefits.
Amid today’s challenges of inflation and elevated hurdle rates, pension fund sponsors should consider turning to private credit markets to optimize performance. Exhibiting sensitivity to interest rate movements – akin to pension liabilities – private credit has historically demonstrated strong positive returns even when equities sell off or rates decline.
Private credit, consisting of privately-negotiated loans extended by non-bank entities, has grown significantly over the past decade and now stands as a pivotal financing mechanism in the global economy. Additionally, it contributes to a more structurally resilient financial system.
Pension plans that are more resilient to illiquidity and credit risk compared to banks, could capitalize on this market as banks exhibit vulnerabilities, notably asset-liability mismatches and subpar default risk management. Private credit provides material return premiums over public credit (high yield) that are derived from alpha (i.e., returns not explained by risk exposure) and fortified by superior downside protections in the form of capital structure seniority and security. It represents, as one former CalPERs CIO put it, one of the few places where an arbitrage exists in today’s financial markets.
Canadian market ripe for private credit
The Canadian market and current climate is particularly ripe for private credit, thanks in part to banks reducing their risk exposure and growing acceptance of this funding mechanism among small and medium-sized businesses. Furthermore, Asset-Based Financing (ABF), a subcategory within private credit, offers an inflation hedge as its cash flows are often contractually secured by tangible collateral, the value of which tends to rise in an inflationary environment.
As we move into the new year and navigate through an economic landscape characterized by decelerating growth, interest rate volatility, and acute sensitivity to inflation, the prudent move for pension funds is clear: augment allocations to private credit, particularly ABF. This strategy stands to outperform equities, provides a valuable hedge against liabilities, and offers diversification in an investment climate fraught with evolving inflation risks.
Arif Bhalwani is CEO and managing director of Third Eye Capital, one of Canada’s largest and longest running private credit firms serving both institutional and retail clients.
 Mark Anson, former CIO of CalPERs and current CEO and CIO of Commonfund, September 28, 2023.