Randy Brown: We're having this discussion the morning after the US elections, and while we don’t know the results on the particulars of Congress, we have the direction of travel of what the next four years may look like from an administration perspective.
When I take a step back, I think about our key priorities as a global company, founded and headquartered in Canada under a Canadian regulator. Within that context, managing and minimising interest rate risk, capital preservation, and excess returns to meet and exceed policyholder and shareholder expectations, have been our focus. These priorities remain constant through time but the manner in which they are best achieved changes in response to the market environment.
We are at a stage of the credit cycle where spreads are at, or near, historic tights. For example, investment-grade corporate credit, which would be the mainstay of most fixed income general account balance sheets, is priced close to perfection. Given these conditions, security selection is key as is credit underwriting.
We also think the risk reward is skewed and have been reducing our exposure to some corporate names to build up dry powder and redeploy it when there is an opportunity.
Some of the opportunities we're seeing now are in public space such as structured finance, which we think has always been inexpensive relative to investment grade corporates and is a product we're comfortable with.
"We've been putting money into non-fixed income asset classes
– such as infrastructure equity and private equity."
We are a higher quality buyer, where you can increase your rating and therefore reduce capital consumption and increase yield relative to public corporates.
On the other side, we have continued to expand into private credit, something we've been doing for decades. It's all the rage today but we have a team of over 60 people primarily dedicated to the general account and have been for a long time. In addition, we have acquired a majority stake in an affiliate company Crescent Capital, which focuses on below investment grade credit, where we've been deploying more capital as we see opportunities on several fronts.
Additionally, we've been putting money into non-fixed income asset classes – such as infrastructure equity and private equity.
How does that change with the election? The expectation is there may be a more supportive regulatory environment for business, a positive for corporates. That goes against the trade that we had talked about earlier.
Now, one could argue the election bodes poorly for renewable energy, but the fact is, there's still more of it, we still need it, and we think there will be opportunities despite political changes.
"The place we may differ from competitors is that
investment grade corporate trade."
For the broader industry, other investors are doing much of the same, particularly in private credit. It's probably our biggest asset exposure and has been for decades. This is not new for us.
The place we may differ from competitors is that investment grade corporate trade, other people think spreads are tight and there's no real risk there. We've gone the other way and done more of a barbell.
Additionally, part of our strategy is what I call “base rate effect trade”. We're going into below investment grade floating rate product, tied to the Secured Overnight Financing Rate (SOFR), because we have a belief, we had it before the election, and it's reinforced after the election, that rates will stay higher for longer and therefore the base rate effect in SOFR is a risk premia worth harvesting.
We've seen that today with interest rates, and again three hours do not a trend make, but the market view on the election is that the [Republican] agenda may be inflationary. That reinforces the idea that rates would stay higher for longer.
Randy: There has been a whipsaw effect on the impact of interest rates on asset allocations. As the Federal Reserve raised rates aggressively the value of the fixed income component of the balance sheets of insurance companies went down. This led to an overweight position in non-fixed income. This change in asset mix, the “denominator effect” on the asset allocation, was a passive outcome which reduced new allocations into alternatives.
That being said, investors are finding value in diversifying their portfolio into alternatives and I'm seeing asset allocations into this space come back up amongst us and our peers. I still believe that non-fixed income assets are important tools that support Sun Life’s long-term investment objectives, and we continue to deploy non-fixed income and alternatives in our investment strategy.
"We think there are opportunities in the real estate market and what
we've seen in Q3 indicates that we are at or near bottom."
The second area of focus is real estate. As a Canadian company, we have more real estate equity than our US and global peers. It's an asset class that we like. Markets where you've seen price dislocations are great for us because we're a long-term non-levered buyer of buildings.
If others reduce their holdings at prices that we find attractive, we can buy them. We think there are opportunities in the real estate market and what we've seen in Q3 on a diversified real estate portfolio indicates that we are at or near bottom.
We still think there's relative value between different subsectors. For instance, office has not yet found its bottom, but other parts might have. Oddly, retail is one of the better performing sectors.
Randy: Speaking from the perspective of an asset owner with a long-term investment horizon for the general account of Sun Life, we think taking these aspects into consideration is important in determining the long-term viability and sustainability of a company’s value. We and most of our peers have always done this. We didn't call it sustainability or ESG in the past but for the fixed income assets that we were lending on for 30 years, we would look at what the long-term viability of a company was.
"Sustainability is broader than the environment; it encapsulates the sustainability
of the company and the sector to survive the next 30 years."
Are they going to be here in 30 years? What do we think about the management team, what do we think about the environmental impact and the environment in which they operate? That last point isn’t referring to climate but rather the political, social, and demographic factors. What's this company going to look like 30 years from now? A simple example is Kodak, which was a market leader, and then came digital cameras. Buggy makers were all the rage and then came the car. We look at industries as a whole.
Sustainability is broader than the environment; it encapsulates the sustainability of the company and the sector to survive the next 30 years and what changes may disrupt it.
We think it's important and we focus on this. I put a lot of economic and financial significance on it.
Sun Life, as a company, has said it's important and we have objectives [around sustainability], which we’re public about. We have set emission reduction targets for part of Sun Life’s general account portfolio for 2030 and plan to achieve net zero by 2050 for these investments.
Randy: It goes back to what I said: where will this industry be in 30 years?
Technological innovation is so much faster than most people believe, or I would say even recognise. It could be right in front of you, but people think it'll happen later.
For example, when I joined Sun Life in January 2016, one of my views was that electric vehicles (EVs) were going to become mainstream sooner than the market had predicted, - the market was thinking EVs were 15 years away.
I said no, it's five years away from being mainstream. How did I form that view? I talked to people and one group that I spoke to were venture capital firms. I asked them the question “What are you not seeing today?”.
The answer I got was “Everyone asks us what we are seeing, but nobody ever asks us what we're not and that’s a need for venture dollars around EVs”.
"A big innovation could be coming, which could form a risk around
stranded assets of legacy internal combustion engine factories."
So, we asked how they interpreted that. Does that mean the tech didn't work and it's going away? Or that it's accelerating and moving past venture into growth? They said it’s accelerating, not disappearing and therefore, the tech will be here sooner rather than later. That made me think about what that means for automakers. What are they 30 years from now?
You could argue they're the winner. You could also easily argue they're the loser.
We don't know what we don’t know. A big innovation could be coming, which could form a risk around stranded assets of legacy internal combustion engine factories from the major automakers and it's a risk that we can't assess.
What we do know is that it's a risk that the market is probably mispricing and therefore we need to shorten the maturity spectrum of where we would lend to auto companies.
That's a real-world example of how you can take a macrotrend such as sustainability, look at the impact on real companies’ increase in stranded risk, and make changes in investment posture.
Randy: We try to factor the same approach to assets in private markets the way we do in the public markets.
The information is more difficult to obtain if you want data, but we also think about these as macro trends. For instance, what is the impact of artificial intelligence on a particular sector of the market, and do we want to have exposure to that sector?
So, it’s a similar approach.
Randy: We have a large mortgage loan book both in Canada and the US. Canadian institutional real estate has been much more stable than the US because it has a stronger group of owners who are less levered and more long-term holders. Therefore, the price volatility has been lower, and those mortgages are fine. We have essentially no arrears in Canada; they're all paying.
It’s a different story for US office; some of the industry-wide mortgages have been under pressure because the buyers were levered, and when the mortgages came due, they were unable to refinance and had to sell. The price was distressed, lowering mortgage valuations.
In the Lifeco industry, we all have big, diversified holdings, including the office sector in the US. There will be speed bumps along the way for everybody, but within the context of a portfolio, we are fine.
Randy: We’re watching it keenly; the market was frozen, and now it's started to unfreeze. You're starting to see more in transaction volume, which is healthy for the market.
"Nobody's building new offices anywhere near the way they used to."
What are we seeing? We have a growing economy, so demand for space over time should rise. Return-to-office mandates are increasing, not decreasing. You have transaction volume picking up as real estate is getting into different hands.
The underpinning is there for that market to recover, but a market like this has almost no new supply. Nobody's building new offices anywhere near the way they used to. That means on a forward basis it'll be fine but to get from here to there it's going to take some time to work through the system.
