Foundations' Fixed Income Challenge

by Richard Phillips, Chief Investment Officer

and Zachary Schwartz, Client Relations


Executive Summary

  • Canadian Foundations often overweight traditional fixed income with yields below their minimum disbursement quotas

  • Foundations do not suffer from the constraints imposed on some institutional investors

  • East West advocates Foundations replace some, or all, of their bonds with Alternative Yield Funds

  • Donors should consider a Foundation’s portfolio construction when assessing endowed versus expendable gifts

  • The East West Alternative Yield Model Portfolio is designed to replace investors’ Canadian bond holdings. It has returned >10% annually on average since its 2016 inception

 
It is more difficult to give money away intelligently than to earn it in the first place.
- Andrew Carnegie

The 2021 Canadian Federal Budget observed that “charitable foundations held over $85 billion in long-term investments.”[1] The government has announced its intention to study an increase to charities’ minimum disbursement quotas (DQ) – the minimum percentage of their holdings they must spend each year on their own activities and in grants to other charities. The DQ is currently 3.5% (it was 4.5% until 2004). In the United States, the DQ equivalent is 5%; whereas, in Europe no such distribution requirements exist.


Many prominent Canadian foundations’ fixed income holdings yield less than 3.5%.In other words, given their mandated disbursements, in the absence of capital gains, these investments will shrink in nominal terms (and wither in real terms). Irrespective of a potential increase in the DQ, many foundations’ portfolios are ill-equipped to meet existing distribution requirements.


East West maintains that investors likely face low future real returns or, potentially, capital losses on traditional bond holdings – an unappealing risk/reward setup (see our previous report, “Too Late to Stop Now – The Case Against Bonds”). This report identifies the fixed income challenges faced by Canadian Foundations, articulates some potential solutions, and advocates for stakeholder scrutiny of their organizations’ investment practices.


Overweight bonds, emaciated returns


A review of ten Toronto-area hospital foundations’ investment portfolios (with endowments between ~$14M and over $1B) puts the fixed income challenge into sharp relief.


East West analysis of latest available audited financial statements. Bonds exclude cash, cash-equivalents, private companies’ debentures, term deposits (of any duration), and undefined “short-term” holdings. If undisclosed, East West assumes that Balanced Funds have a 30% weighting in bonds.

Given the idiosyncrasies of individual hospital foundations and their differing short-term funding commitments or policies, we exclude short-term holdings for the purposes of this analysis.We can make reasonable assumptions on bond yields for those foundations that elect not to disclose them by looking to widely used reference indices – the same proxies we use for Canadian bonds when assessing the performance of East West’s Alternative Yield Model Portfolio.


The S&P Canada Aggregate Bond Index weighted average yield to maturity is 1.6% and the FTSE Core Canadian Bond Universe weighted average yield to maturity is 1.7%.They have modified durations of 7 years and 8 years respectively.In Q1 2021, the former index lost 4.9% and the latter fell by 5.7%.As the predicate for nominal returns in excess of the DQ (currently 3.5%) is therefore capital appreciation – i.e., a further decline in interest rates – trustees and donors might wonder whether a diet of 34% bonds (the median in the table above) will yield adequate returns going forward. Notably, these yields are below the Canadian inflation rate, and substantially below the sum of the inflation rate and the Disbursement Quota (a sum which must be exceeded in order to prevent foundation asset levels from declining in real terms):

DQ 3.5% + Inflation (X%) = Min. Required Nominal Return (3.5% + X%)


Endowed with Advantages


By overweighting traditional, low-yielding bonds, foundations eschew advantages they enjoy relative to other investors (including their benefactors). Donors’ net returns on personal or corporate investment must account for tax headwinds, which may alter the risk/return calculus of allocating to yield-generating vehicles. Foundations are liberated from this tax encumbrance.


In a similar vein, insurance companies as well as pension funds face regulatory constraints, which require them to hold traditional bonds and limit their opportunities to participate in products which provide improved yield. Indeed, these regulatory mandates foster inefficiencies in the Canadian bond market that foundations can exploit.


Larger institutional investors also face challenges in deploying capital efficiently into Alternative Investment Funds: some strategies have capacity constraints that preclude substantial LP participation. Many Canadian foundations do not face the same regulatory, legal, or tax limitations which pension funds, insurance companies, corporations, and individuals face.


In short, many Canadian foundations enjoy structural investment advantages, which they leave on the table with their significant current bond holdings.


An Alternative Universe


East West believes that an optimally constructed portfolio should include yield generating assets. The East West Alternative Yield Model Portfolio emphasizes safety of capital, strong yield, and good liquidity.It replaces some or all of a traditional Canadian fixed income portfolio.


In previous research articles, we identify two key advantages of Alternative Yield allocations for Canadian investors: generating substantive predictable cash flows and acting as a ballast against equity market volatility. Both are applicable to foundations and the latter particularly important given potentially increasing correlations between stocks and bonds (discussed in our report, “The End of an Era”).


Importantly, investing in Alternative Yield securities should enable foundations to meet their DQs, grow assets in real terms, and avoid liquidating equity positions during market drawdowns. The East West Alternative Yield Model Portfolio is less volatile than traditional Canadian bond portfolios.


Additional Investment Challenges


Though beyond the scope of this article, we encourage foundation donors, Trustees, and executives to consider the following:

  • How will the foundation’s future disbursements evolve?

  • Government mandated increases may be on the horizon.

  • What are the foundation’s inflation expectations?

  • In our experience, inflation in certain areas – e.g., education, healthcare – can meaningfully exceed CPI changes.

  • When did the foundation last revise its IPS and manager selections procedures?

  • These may be materially outdated and may not allow for the foundation to take advantage of the many opportunities for yield.


Alternative Yield Portfolio Advisory


The construction and ongoing management of Alternative Yield portfolios require expertise for foundations to achieve favourable risk/reward outcomes. Allocations must account for macroeconomic factors in addition to analysis of individual managers. Indeed, as discussed in our article, “Manager Selection: East West’s Approach,” there is significant return dispersion amongst alternative asset managers.


At East West, we encourage asset allocations in four categories as part of a diversified Alternative Yield portfolio:Private Lending; Real Assets; Credit; and, Specialized. Our holistic approach to selecting a specific manager in these verticals encompasses analysis of safety of capital, running yield, total return, liquidity, tax character, integrity, track record, risk, and collateral.


East West ensures that portfolios benefit from diversification at both the portfolio level (asset and sub-asset classes) as well as at the individual manager level.East West’s advisory and active management of Alternative Yield Funds targets adding significant alpha to foundations’ fixed income portfolios.


Conclusion: Stewards of Capital


Too many Canadian foundations are poorly positioned to meet the existing disbursement quota – let alone a potential increase – without capital erosion. Executives and Trustees should consider shifting a component of their low-return and potentially risky bond portfolios to Alternative Yield investments.


Philanthropists should scrutinize charities’ investment policies. If donors believe that endowed capital is too skewed toward very low yielding investments, they might consider investing through their own foundations or donor-advised funds, making annual, fully-expendable gifts to charitable organizations.


At East West, we believe that the Alternative Yield Model Portfolio can help many foundations meet their income challenges and benefit all stakeholders. Please feel free to contact us for advice in this area.


 

[1] Notably, the MasterCard Foundation accounts for more than $40 billion of those assets.