Institutions returning, cautiously, to leverage

Low interest rates and cheap credit have emboldened several asset owners to add leverage, after years of avoidance.

The use can appear in different forms, such as risk-parity strategies, borrowing against assets or by buying swaps or Treasury futures. The goal: hedge liabilities, improve returns or make tactical moves.

Recent examples where plans have either sought the use of leverage for the first time or increased their allocation to strategies with embedded leverage include:

• the $24 billion Texas Municipal Retirement System, Austin, which made its first opportunistic credit investments in June totaling $700 million — $300 million to three Marathon Asset Management funds; $200 million to Beach Point Capital Management's Total Return Fund II; and $200 million to Pacific Investment Management Co.'s Corporate Opportunities Fund II;

• the $3.6 billion Kern County Employees' Retirement Association, Bakersfield, Calif., which in July added a target allocation of 5% to private credit and doubled its target to real estate to 10%, from 5%; and

• the $830 million Ohio State Highway Patrol Retirement System, Columbus, which committed $30 million to two opportunistic funds — $15 million to PIMCO Corporate Opportunities Fund II in April and $15 million to Marathon European Credit Opportunity Fund III in June — after increasing its target alternatives allocation to 25%, from 17.5%, late last year.

Kane Brenan, a partner at Goldman Sachs Asset Management and head of its global portfolio solutions group in the U.S., said in a telephone interview that more pension plans are becoming more comfortable with leverage than they were a few years ago — and are using it for different purposes.

"We're seeing pension plans use leverage in three ways: to hedge their liabilities better; to seek similar returns in a new, well-diversified portfolio compared with the returns when they had a more equity-centric portfolio; and to implement tactical views quickly and efficiently," said Mr. Brenan.

Mr. Brenan added he's seeing more “smart” use of leverage by institutional investors — that is, to manage interest rate risk, unlike the most common uses of leverage right before the financial crisis.

“This is not a 'bet the farm' tactic; it's plans saying, 'Let's manage our portfolio in a reasonable way,'” he said.

Institutional investors had used embedded leverage for years, whether it was through private equity funds, real estate funds, hedge funds or risk-parity strategies. Those embedded forms of leverage included in these strategies didn't show up on the asset owners' balance sheet.

When the financial crisis hit, however, some sources of that embedded leverage proved a major contributor to the massive real estate meltdown. That left sponsors gun-shy about those strategies.

Although investment returns were strong the first few years after the crisis, especially within equity markets, they've been anemic in recent years. Data from Willis Towers Watson show the median rates of return for the largest defined benefit plans were 17.3% in 2009 and 12% in 2010. But in 2011, that average dropped to 2.4%.

Investors are facing an extended period of low returns from traditional drivers of long-term returns. Leverage offers one avenue for bolstering those returns.

“It's about a change in the way that asset owners are thinking about their balance sheets,” said Erik Knutzen, multiasset-class chief investment officer at Neuberger Berman Group LLC, New York. “If you know you have a very long investment time horizon, then you can add leverage and improve your expected rate of return.”

But Mr. Knutzen added that it “requires very sophisticated risk management and controls and the appropriate governance structure.”

Peter Austin, a vice president of T. Rowe Price Group Inc. and head of multiasset solutions in the Baltimore-based firm's asset allocation group, also noted that asset owners have become more comfortable returning to the use of leverage in recent years, in part because of the current market environment.

“There has been an increased interest from large public plans to employ strategies that incorporate leverage as a means to enhance returns,” Mr. Austin said, strategies that were avoided after the global financial crisis.

But in the current lower-for-longer return environment, most asset class returns have been disappointing. Hedge funds in particular have struggled to deliver the returns that asset owners expected and were accustomed to receiving.

Plans such as the $305.7 billion California Public Employees' Retirement System have moved away from hedge funds in favor of strategies designed to achieve equity returns, such as private equity and real estate.

“Publics need return. Because public plans have the benefit of time and aren't marking to market their liabilities the way corporate plans are, I've seen an increase in interest in leverage among publics,” Mr. Austin added.

CalPERS spokeswoman Rosanna Westmoreland said in an e-mail that the Sacramento-based fund uses leverage “for a variety of purposes, including … leverage embedded within limited partnership structures for the purchase of real assets, notional leverage achieving market exposure using equity and fixed-income futures and swaps and can use leverage to generate liquidity.”

She added: “We are planning to consider the question of using additional leverage during our upcoming asset-liability management planning process.”

At the Ohio Police & Fire Pension Fund, the focus was on reducing risk at the overall portfolio level, said spokesman David Graham. The investment board of the $13.7 billion plan originally selected a 1.2 times leveraged policy portfolio, which didn't increase expected return relative to the prior policy portfolio of no leverage, but did reduce expected risk.

“The approach created a more risk-balanced portfolio by reducing the portfolio's risk contribution from equities and increasing the risk contribution from fixed income through levered fixed-income mandates, which reduces overall expected risk without sacrificing return,” Mr. Graham said.

The Columbus-based fund has been reducing equity risk and has two-times leveraged global inflation-protected bond mandate of $1.2 billion in place. However, it has not yet implemented other leveraged bond exposures.

The Florida State Board of Administration, like CalPERS, also uses leverage, said John Kuczwanski, spokesman for the $179.5 billion Tallahassee plan.

Some of the FSBA's hedge fund strategies and real estate funds use leverage, he said. The FSBA will also sometimes use leverage when buying or financing real estate internally.

“Leverage can be used to offset or hedge other types of risk in the portfolio,” Mr. Kuczwanski said. “Additionally, it may make sense to (use) leverage when financing rates for real estate are low.”

That said, the FSBA is wary of upping the usage of leverage because of the potential damage it can do to the portfolio. “We have no plans, nor are we open to the idea of using additional leverage,” said Mr. Kuczwanski. “Utilizing leverage can introduce additional investment risk, volatility, counterparty risk and complexity to the portfolio.”

The FSBA oversees $180.5 billion, including the $144.1 billion Florida Retirement System defined benefit plan.

Although T. Rowe Price's Mr. Austin said that leverage is far less common among corporate DB plans than public plans — because corporate plans are relative-return investors where the return they're investing against is that of their liabilities — others have noticed growth.

“We see corporate pension plans using leverage a number of different ways, but they're all trying to achieve the same objective: risk reduction,” said Gary Veerman, managing director at BlackRock Inc. and a member of its U.S. client solutions group within BlackRock Solutions, New York.

Mr. Veerman said he's had a number of conversations recently with corporate clients about using swaps and Treasury futures in situations in which a significant return is needed from limited available capital.

“Leverage can be a powerful tool for risk reduction,” Mr. Veerman added.

In discussing the use of leverage among corporate pension plans, Jay Love, Atlanta-based partner and senior consultant at Mercer Investment Consulting, said the shift to liability-driven investing typically has some component of leverage.

“In corporate plans, there's generally been an increase,” Mr. Love said. “It's not used in an aggressive way. It's used to hedge the liability side.”