Did Calpers just call the peak in the Fed-blessed bond bubble which has seen a record $1.1 trillion in new issuance in 2020?
The $395 billion California public pension giant, best known for unwinding its market hedges at the all time highs just days before the March crash giving up on a $1 billion payday, which has failed to hit its return bogey for much of the past decade is reportedly set to take on substantial leverage via borrowings and financial instruments such as equity futures, the FT reports, noting that leverage could be as high as 20% of the value of the fund, or nearly $80bn based on current assets. The purpose of all this extra debt is to juice up returns of Calpers and help it achieve its growth target.
Calpers decision was almost certainly predicated by the Fed's explicit backstop of debt, with the central bank now purchasing both IG and Junk ETFs and soon set to buy corporate bonds outright limiting - in Calpers view - the downside risk on this leverage plan.
The stunning shift was unveiled in a presentation to the Calpers board by chief investment officer Ben Meng, and comes after a 2019 investment strategy review "that found Calpers needed greater focus on the excess returns potentially available from illiquid assets compared with public equity and debt. Under Calpers’ previous asset allocation strategy it was estimated to have a less than 40% probability of achieving its 7 per cent return target over the next decade."
"Given the current low-yield and low-growth environment, there are only a few asset classes with a long-term expected return clearing the 7 per cent hurdle. Private assets clearly stand out," Meng said. “Leverage will increase the volatility of returns but Calpers’ long-term horizon should enable us to tolerate this.” He added that leverage would not “be tied to any specific strategy, asset, fund or deal”.
According to the FT, Calpers’ portfolio has also been de-risked by increasing its holdings in longer-dated US Treasuries and switching more assets from capitalisation-related equity indices to factor-weighted equities. These use indices that focus on investment styles such as price momentum or volatility, which have suffered dramatic volatility since the March crash.
According to Mr Meng this strategy protected the fund from losses of $11bn in the pandemic-induced market slide, which far outweighed the $1bn profit forgone on tail risk hedging. He said that unlike in the financial crisis of 2008 Calpers was not forced to sell assets into a depressed market in March. “Too little liquidity can be deadly but too much is costly,” he said.
So to make sure that it not only does not achieve its 7% bogey but suffers massive losses in the next financial crisis, the pension giant is now levering up with stocks not too far from all time highs, and with bond yields once again near all time lows, a combination which ensures that California's pensioners will not only not have fully funded pensions, but will suffer major losses on their current life savings.
Adding insult to injury, the FT reminds us that Calpers’ assets represent just 71% of what it needs to pay future benefits to the 1.9m police officers, firefighters and other public workers who are members of the scheme.
The US stock market slide this year has increased the long-term structural problems across the entire US public pension system, particularly for the weakest plans that have ballooning unfunded liabilities. In fact, some speculate that "Central Banks Bailed Out Markets To Avoid Trillions In Pension Losses."
Needless to say, the weak funded position of these funds poses a huge long-term risk for millions of US employees and retired workers. The problem is that applying 20% leverage to juice returns, also adds to downside risk, which means that the Fed will be even more pressures to eliminate downside risk from stocks and bonds unless it wants to see anger spillover into the streets as millions of public workers learn their promised pension payoffs will never materialize.