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Moody’s: More leverage, illiquids ups risks for large public funds

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The six largest Canadian pension funds have increased their leverage by five percentage points since 2009 on an aggregated average – placing a potentially greater strain on their sponsors, according to Moody’s.

The analysis looked at funds including the Canada Pension Plan, Ontario Teachers’ Pension Plan (OTPP), and Caisse de dépôt et placement du Québec.

Over the past several years the funds have developed into new asset classes such as short-term commercial paper and medium-term notes, equity short-selling and secured real estate mortgage investment strategies to diversify funding sources, enhance fund liquidity and increase return, the rating agency said in a note on Canadian pension funds last week.

“The combination of higher leverage and less-liquid investments raises risks for pension funds, increasing future return volatility,” Moody’s analysts said. This magnified losses as well as gains, increasing funds’ sensitivity to interest rate increases, and adding counterparty credit risk for transactions that were not centrally cleared.

The rating agency continued: “Although Canada’s six largest pension plans have nearly doubled in size, on a combined basis, in the past five years, which gives them more negotiating power to lower transaction costs and participate in larger investment opportunities, efficiencies have only partially offset lower returns.”

Ontario Municipal Employees Retirement System held a large portfolio of real estate assets, financing it with secured term debt, while OTPP and the Healthcare of Ontario Pension Plan both held a large proportion of fixed income to support repo and derivative leverage strategies, the rating agency said.

In addition to taking on more leverage, Canadian pension funds have been allocating to higher-yielding, less-liquid asset classes to offset cash flow pressure an ageing membership base.

The rating agency said increased leverage and higher model risk – from increased allocations to less liquid assets – were “credit negative” for the connected entities it rated (including the provinces of Ontario and Quebec and the Canadian government) but also tended to have constructive rationale in that they were designed to reduce funding risk and ensure plan sustainability.

“Diversification of leverage sources improves funds’ liquidity, helping them weather market downturns and take advantage of investment opportunities without the need to immediately sell other investments,” said the Moody’s analysts. “As well, investment returns of private assets are typically higher because of a liquidity risk premium.”

However, Moody’s also warned that “should a prolonged decline in investment values materialise, higher interest costs and lower liquidity would further strain fund cash flows”.

It added: “This could result in cuts to retiree benefits and/or increases to contribution rates from employees, and employers would commensurately reduce liabilities and/or bolster pension plan asset positions.”

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