WORKERS CAPITAL
Big bond market moves are coming, says nation's largest local pension plan

Story by Eric Rosenbaum • Yesterday 

Last year stood out in market history for being a bad one for both stocks and bonds, and so far in 2023, stocks have surprised with a tech-led rally.

But one of the biggest investing shifts taking place among the largest institutional investors this year is a move into bonds for a higher interest rate economy, but not the classic 60-40 portfolio, which has rallied but which BlackRock wrote in a note this week investors should avoid.

Jonathan Grabel, chief investment officer for LACERA, the largest county pension plan in the U.S., tells CNBC he expects to be making portfolio allocation changes to focus more on fixed income, and the moves made by his Los Angeles fund and other pension giants will have big implications for the markets.




A year into the most significant period of Federal Reserve rate hikes in decades, you might think investors had already cemented their investment portfolio strategies for a higher interest rate world. But some of the biggest investors are making, or first planning, some of their biggest moves now.

Count the largest county retirement plan in the U.S. among the list of elite investors planning to bulk up on bonds as a result of the higher interest rate environment. That was the message delivered by Jonathan Grabel, chief investment officer for the Los Angeles County Employees Retirement Association (LACERA) at CNBC's Sustainable Returns virtual event on Wednesday. And he says a coming portfolio reallocation process will have big implications for the markets and economy.

"I think that the changing market environment with higher rates potentially changes everything, it changes how we think about allocation," Grabel told CNBC's Frank Holland. This summer, the LACERA CIO said, the pension plan — which invests on behalf of 180,000 active and former workers in LA County and has roughly $70 billion in assets — will "revisit" its strategic asset allocation, he said.

As the pension giant seeks an overall return of 7%, Grabel said the summer review will consider changes to its stock, bonds, real estate and real assets allocations. "To the extent we can get there [7%] and can get more through safer fixed-income investments it might change the amount of capital we have in riskier complex equity-like investments."

LACERA isn't alone among big investors talking about how the higher interest rates are changing portfolio allocation decisions, especially when it comes to private market equity and alternative investments. Fellow California pension giant CalSTRS is making a bigger move into bonds, according to a Wall Street Journal report from earlier this month. "Bonds are back," CalSTRS investment chief Chris Ailman told the Journal.

According to LACERA's 2022 annual report, its investments were split between roughly $24 billion in public equities, $19 billion in bonds, $13 billion in private equity, $6 billion in real estate, $4 billion in hedge funds and $1 billion in real assets.

Last year was the first in the prior three fiscal years that the pension fund's investment portfolio lost money. While it still managed to outperform its benchmark, returns fell well short of its actuarial assumptions for a 7% return.

The net investment loss for fiscal year 2022 was approximately $1.5 billion, a decrease of $17.1 billion from the 2021 fiscal year, when the net investment gain was $15.6 billion, and which it attributed to "challenging market conditions in the first half of 2022, including war in Europe, high inflation, and an economic slowdown in China."

By contrast, investment returns of 25.2% in 2021 were far ahead of the 7% percent, which LACERA attributed to the strong performance from global equity and private equity assets.

A shift to more fixed income among top investors will flow through to the "whole economy," Grabel said. "We are mindful of that as investors have less in risky assets it changes how corporations allocation capital," he said.

"That really raises the demand and need and requirement for boards focused on excellence, and where access to capital is," he added at the CNBC event focused on sustainability and investing.

LACERA was not scheduled for one of its formal three- to five-year portfolio reviews this summer, which was last completed in 2021, and included the creation of new asset allocation buckets.

Why pension funds are moving more to bonds now

Major moves by large institutions managing billions of dollars based on long-term return assumptions take time to enact, so it should not be a surprise that some of the more significant moves related to rising rates are first taking place now. According to pension consultant Callan, a shift to more fixed income is the expectation in asset allocation plans to come from more pension funds, especially as annual capital markets assumptions used by chief investment officers tilt the equation to more bonds.

Callan's latest projections for the decade from 2023-2032 show greater returns from core bonds after an extended period of time when spreads and yields were very tight, making the public bond market less attractive. "A lot has changed in the world and AGG [the Bloomberg Aggregate Bond Index] looks a lot more attractive," said Kyle Fekete, vice president and a fixed income specialist in Callan's global manager research group.

The risk-return profile for investment grade bonds is a good example. Callan's 2022 capital market assumptions projected a return of 1.75% for U.S. core bonds versus a risk profile of 3.75% for the fixed income asset class. This year, the outlook is for a return profile of 4.25% versus projected risk of 4.10%.

Callan analysis of how a portfolio would have been structured a decade ago to generate a long-term return for pension liabilities versus how it should be structured today shows a bigger increase in fixed income. "And that's a lot of food for thought for plan sponsors and discussions are going around the investment community," Fekete said, with most asset allocation changes so far, which could include investment grade and high yield, on the margins.

"It hasn't happened just yet, but it will happen over time," he said. It will have implications for private market investments and growth investments, he added, as yields offered on public fixed income improve and don't require taking illiquidity risk.

More fixed income does not mean more 60-40 portfolios

This does not necessarily mean a shift back to the 60-40 stocks/bonds approach that had been left for dead in the years of high stock market returns and ultra-low interest rates.

While that traditional investing concept has had a better year in 2023, and some investors are now backing it again, some big institutions say it is still time to ditch it, including BlackRock. In a report out this week, the BlackRock Investment Institute said the terrible returns last year for the 60-40 portfolio followed by the great returns this year should both be discounted.

"We don't see the return of a joint stock-bond bull market like we saw in the Great Moderation. That was a decades-long period of largely stable activity and inflation when most assets rallied and bonds provided diversification when stocks slumped. We think strategic allocations of five years and beyond built on these old assumptions do not reflect the new regime we're in – one where major central banks are hiking interest rates into recession to try to bring inflation down."

Bonds won't provide the "reliable" diversification they have in prior years, "but higher yields mean income is finally back in fixed income," its team wrote. Overall, BlackRock says a focus on broad portfolio concepts is a mistake going forward, but for now, the rising rates do mean more focus on income plays.

"The longer rates stay higher, the greater the appeal of income in short-term bonds. We see interest rates staying higher as the Federal Reserve seeks to curb sticky inflation – and we don't see the Fed coming to the rescue by cutting rates or a return to a historically low interest rate environment. This reinforces the appeal of income in short-term paper. Yet we also see long-term yields rising on both strategic and tactical horizons as investors demand more term premium, or compensation for holding long-term bonds in an environment of higher inflation and debt."

Recent commentary from Wall Street bank CEOs during their earnings period suggest rates will remain higher for longer despite traders betting on cuts from the Fed this year. Morgan Stanley CEO James Gorman said the Fed may have two more interest rate hikes, while Jamie Dimon CEO said last Friday that 6% interest rates could be coming, a potential reality that Gorman also said would be "not shocking."

BlackRock is overweight inflation-linked bonds, its team wrote, based on expectations of persistent inflation.