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Inflation-protected assets leap; active fixed income is steady

16.8% TIPS increase is a sharp contrast to overall boost of 0.4%

Pennsylvania Public School Employees’ Retirement System CIO James Grossman

Pension funds held the line on their overall active U.S. fixed-income allocations for the 12 months ended Sept. 30, although some were adding to their inflation-protected holdings, according to the results of Pensions & Investments' latest survey of the 1,000 largest U.S. retirement plan sponsors.

Overall, active domestic bond investments among the 200 largest defined benefit plans totaled $668.3 billion, a meager 0.4% increase from Sept. 30, 2016. However, sponsors reported $88.9 billion in Treasury inflation-protected securities, a 16.8% jump.

Among the plans reporting large increases in TIPS investments was the Massachusetts Pension Reserves Investment Management Board, Boston, which in February 2017 increased its allocation to the asset class by 2 percentage points, to 5% of total assets, said J. Chuck LaPosta, MassPRIM's senior investment officer, fixed income. MassPRIM reported $3.5 billion in TIPS as of Sept. 30, up more than 70% from a year earlier.

The move to TIPS was "proactive," Mr. LaPosta said. "We did it more on the protection side than the return side."

MassPRIM funded the change by reducing its exposure to long-only Treasuries by 2 percentage points to 2% of total assets. "That (long Treasury) allocation was used as an offset to inflation protection, and we decided to replace it with TIPS," Mr. LaPosta said.

Other defined benefit plans reporting sizable percentage increases in TIPS allocations included the Ohio Public Employees Retirement System, Columbus, up 75.4% to $2.3 billion. The California Public Employees' Retirement System, Sacramento, had the most assets invested in TIPS investments at $19.4 billion, up 12.1%. CalPERS also led in active domestic fixed income, at $58 billion, up 11.5%.

Officials at Ohio PERS could not be reached for comment; CalPERS officials declined to comment.

The 143.7% increase in the TIPS assets of the Pennsylvania Public School Employees' Retirement System, Harrisburg, to $7.8 billion, was due to the inclusion of leveraged assets for the first time in the latest P&I survey, said James Grossman, chief investment officer. The inclusion also explains the 68% increase in PennPSERS' overall U.S. fixed-income assets, to $12.09 billion.

"We use leverage in our allocation," Mr. Grossman said. "The increases in domestic fixed income and TIPS relate to that. The increase is on an economic basis." The plan has maintained its 15% allocation to TIPS from 2016.

Generally, PennPSERS "holds more fixed income than most plans like us so that we have an overall balanced exposure," said Mr. Grossman, adding that in 2007, 95% of the pension fund's investment risk came from equities, he said, vs. 60% today. "We take a more risk-balanced approach," he said.

Clients of investment consult- ant Callan LLC expressed an interest in TIPS investments in the past year because of expectations of inflation that ultimately never materialized as the year went on, said Nathan Wong, San Francisco-based vice president and fixed-income investment consultant.

"I think, coming on the heels of (the 2016) election, the (Trump) administration created a platform with more infrastructure as their focus going forward, which would have spurred more inflation," Mr. Wong said. "Also, with plans for tax reform, some people were making a bet on higher inflation if that got passed. If you look back to last year, people were certain that inflation would go up but the expectations got lower later in the year. With tax reform passed, we could see a repeat of last year" in terms of rising inflation expectations.

Signs of higher inflation

MassPRIM's Mr. LaPosta agreed that signs early last year pointed to higher inflation. "At the time, inflation was at historic lows and the cost of insuring for inflation was also low," Mr. LaPosta said. "While inflation was not imminent, it could have been damaging to our overall portfolio. So we did it from a strategic perspective."

Added Brad Camden, director, fixed-income strategy, at Northern Trust Asset Management, Chicago, "What we have seen is strong buying of TIPS as cheap insurance. That ebbs and flows over time."

Mr. Camden said the use of TIPS in investments "varies, depending on who's running the plan... For some, TIPS are used to improve yield and return. For others, they can be used for risk mitigation. There is a duration point to TIPS. If markets rally, you get a total return out of them. If you have risk assets, and they perform exceptionally well, some will ask what's the risk to bonds, how do you protect that? TIPS are a way of doing that."

While TIPS investments increased, the relatively flat levels in overall active bond investing isn't too surprising but could change going forward, Callan's Mr. Wong said.

"Obviously, the yield environment is not entirely attractive," he said. "Returns have been pretty paltry. In terms of public plans, it's perhaps the downside protection plus the runup in the equity market."