Long bonds are key to protecting pension surpluses, argues RPIA's Liam O'Sullivan
For many defined benefit (DB) pension plans, long bonds aren’t exactly the sexiest piece of the portfolio. They’re not where boards chase alpha or where managers roll out new innovations.
But Liam O’Sullivan, co-head of client and product solutions at RP Investment Advisors (RPIA), believes ignoring the long-duration bucket is a costly oversight, especially now that many pension plans are operating at a surplus.
“When people talk about long bonds, they're really talking about bonds that are 10 to 30 years in maturity,” O’Sullivan explained. “It's a significant part of the market in Canada and elsewhere. The main investors in these things are either DB plans or life insurance companies because they have liabilities that they know they need to meet in 10 plus years so they're trying to build portfolios to help make sure they can honor those liabilities. But a key part of it is investing in long bonds because they help hedge those liabilities that are projected in the future.”
He outlined a common structure used by pension plans: splitting the portfolio into two main segments. One is the liability-hedging bucket, composed primarily of long-dated government and corporate bonds. The other is the return-seeking bucket, which includes higher-growth assets.
When asked about the role long bonds serve in a pension portfolio, O’Sullivan emphasized the primary function is to manage risk. For pension plans and insurers, which are subject to strict regulatory frameworks, long bonds offer a way to ensure that long-term obligations can be met with confidence. While bonds can serve purposes like liquidity and diversification, in this context, their main role is liability hedging.
While pension portfolios are generally structured with both risk-reducing and return-seeking components, most of the attention from investment committees tends to fall on the return side. In his experience, the liability-hedging segment often gets sidelined, O’Sullivan explained, adding that committees, which usually meet quarterly, have limited time and tend to prioritize higher-return discussions.
Additionally, O’Sullivan acknowledged how heavily concentrated some pension plans are when it comes to the managers overseeing their liability-hedging portfolios. In his view, that level of reliance on a single firm introduces several risks – everything from ownership changes, staff turnover, or underinvestment in key infrastructure. All of that can directly impact the performance and stability of the allocation.
Beyond those operational concerns, he believes pension plans are missing an opportunity by not diversifying manager styles. He drew a parallel with equity investing, where it’s common to blend value, growth, large cap, and small cap strategies.
He was also quick to challenge a common mindset among pension plans: that investment risk belongs solely in the return-seeking portion of the portfolio, while the liability-hedging segment should be left untouched.
This rigid division, he argued, can lead to missed opportunities.
“It’s that sort of bifurcated approach to the portfolio,” he said. While he agreed that risk should not be increased in the hedging bucket, he stressed that improvements can still be made without compromising the plan’s stability.
The real issue, in his view, is the misconception that the liability-hedging segment doesn’t require innovation.
“We would say, actually some of the lowest hanging fruit is within that bucket,” he noted.
He also suggests that the lack of innovation in Canada’s long bond offerings plays a role in this neglect, notably as the available strategies have historically been conventional and uninspired.
“When you look at the relative performance of the options, they're all fairly similar so I think that also probably has contributed to a lack of attention on that part of the portfolio,” O’Sullivan added.
When RPIA analyzed the performance of the three main long bond strategies available in Canada - long core, long core plus, and long corporate - they found limited value being delivered to investors. Particularly, the value gross of fees had been on a rolling three-year basis between zero and 50 basis points, he explained.
Consequently, once management fees are factored in, any marginal gains are largely wiped out.
“Wherever there was a little bit of added value, it was coming just from taking a bit more risk than the benchmark,” he said.
He attributed this underperformance to the domestic focus of most strategies. The Canadian corporate bond market is both small and heavily concentrated, which limits diversification and makes active management less effective.
According to O’Sullivan, financials, utilities, and energy and/or industrials dominate roughly 76 per cent of the long corporate bond space, whereas the US market has significantly more bonds and issuers, offering a broader opportunity set. As a result, a purely Canadian long bond strategy faces structural challenges.
“If you just pursue a domestic approach, it's going to be very hard to add value,” he said.
That insight shaped RPIA’s strategy. Instead of chasing returns by increasing credit risk, they focused on making smarter risk decisions. RPIA has since run a corporate bond strategy that actively invests beyond Canada while maintaining strict risk controls.
“It's a portfolio that invests in Canadian bonds and non-Canadian bonds, but we hedge the duration exposure back to Canada and the currency exposure back to Canada. That's really important because our investors in that strategy want us to outperform the benchmark, but in a really risk-disciplined fashion,” explained O’Sullivan.
