Thursday, August 15, 2019

Investment Insights

Three things your financial custodians should be doing

By Bo Abesamis/Callan

A custodian is a specialized financial institution (typically, a regulated entity with granted authority like a bank) that holds customers’ securities for safekeeping in order to minimize the risk of their misappropriation, misuse, theft, and/or loss.

A custodian has three primary responsibilities:

  1. Safekeeping of Assets: maintaining proper indicia of ownership, valuation, accounting, and reporting of assets owned by a plan/fund sponsor or an institutional investor
  2. Trade Processing: tracking, settling, and reconciling assets that are acquired and disposed of by the investor—either directly or indirectly—through delegated authority with an asset manager
  3. Asset Servicing: maintaining all economic benefits of ownership such as income collection, corporate actions, and proxy issues

The custodian holds securities and other assets in electronic (e.g., the DTC, Fed Book Entry, CLEARSTREAM, CEDEL) or physical form (e.g., vaulting of actual physical certificates or precious metals). Given the size and value of assets and securities held by a custodian on behalf of clients, custodians tend to be large, well-capitalized, and reputable firms. A custodian is sometimes referred to as a “custodian bank.”

A custodian is often used by institutional investors, mutual funds, investment managers offering collective investment funds, commingled vehicles (like UCITs, SICAVs, and SIFs), private equity funds and other private investment funds, ERISA plans, sovereign wealth funds, public funds, nonprofits, high net worth investors, and retail investors for the safekeeping of assets. A true custodian bank would have assets under custody separate from the bank’s balance sheet and maintained as distinct from bank assets not subject to bank creditors. Assets under custody by a qualified custodian are different and should not be construed as a bank deposit and/or brokerage account. Protection against bankruptcy or insolvency of the adviser or custodian is established by segregating the assets and identifying them as being held on the client’s behalf.

In cases where investment advisers are responsible for customer funds, the adviser must follow the Custody Rule set forth by the Securities and Exchange Commission. Refer to the SEC Investor Bulletin: Custody of Your Investment Assets for more information.

There are also nuances to qualified entities offering custodian services. A common misconception is that all custodians are the same. Understanding the difference between a depository and non-depository custodian is imperative.

Depository custodian banks are regulated by the Federal Reserve and subject to a higher standard on compliance, capitalization requirements, and overall code of conduct. A non-depository custodian would technically require a true depository custodian bank to conduct money movement. A depository custodian bank under the regulatory oversight of the Federal Reserve and the FDIC would have the necessary infrastructure to use the ABA wire platform and appropriate bank routing protocol. This would then ensure that the custodian bank would be able to track all money movements into and out of the client accounts. The federal oversight also ensures that proper regulatory checks (i.e., Anti-Money Laundering and Patriot Act requirements) are met without much burden on the client. Custodian banks are depository institutions, meaning they have to comply with Federal Reserve standards and possess the proven infrastructure for all non-negotiable requirements based on federally mandated wiring protocols.

The custodian is often referred to as the gatekeeper of assets whose function is to track monies and assets moving into and out of the account; and they are entrusted to render regular financial valuation of such assets held in custody.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Callan nor TEXPERS, and are subject to revision over time.

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Wednesday, August 14, 2019

Investment Insights

Debt, downgrades and fallen angels: 

Keeping risks in perspective

By Matthew Sheridan, Matthew Minnetian & Gershon Distenfeld/AllianceBernstein

The market has grown less anxious about an imminent wave of bond downgrades. That’s good, because overestimating the risk can lead to missed opportunities. But the risk hasn’t disappeared, making research as important as ever.

At the end of 2018, nearly $140 billion worth of BBB-rated bonds were trading as if they were already below investment grade, reflecting widespread concern about unsustainable corporate leverage. That’s the kind of thing bond investors find hard to ignore—with good reason. A wave of downgrades could lock in big losses for investment-grade strategies and spark a disruptive repricing in the high-yield market, a risk for high-income-oriented portfolios.

At the time, we said that a group of US investment-grade bonds worth a much smaller amount were at risk of becoming fallen angels, as formerly high-grade bonds are known. Our research suggests about $80 billion worth could tumble to high yield (Display 1), and we think the process could take years to play out.

Click chart to enlarge.

The market has recently edged a bit closer to our point of view. Demand for BBB-rated bonds surged in the first quarter, with the sector delivering returns of nearly 6%. Why the change of heart? Probably because conditions have changed. Six months ago, the Federal Reserve expected to raise rates three times in 2019. Now, it says it won’t raise them this year at all. This may sustain US growth and ease pressure on corporate borrowers.

Don’t get us wrong: some of the companies still clinging to the bottom rung of the investment-grade ladder will become fallen angels this year. That’s not so unusual, though. A certain number of investment-grade bonds are downgraded to high yield every year— about $72 billion worth on average each year between 2009 and 2018 (Display 2).

Click chart to enlarge.

Fallen-angel volume was high after the global financial crisis and following a plunge in oil prices in 2014 and 2015, though this did not overwhelm the high-yield market. Recently, there have been more rising stars—bonds that were upgraded from high-yield to investment-grade status—than fallen angels, a trend that has continued so far in 2019.

Even so, performance will depend on investors’ ability to distinguish between those bonds likely to fall and those that the market is erroneously pricing as high-yield credits. This requires an internal ratings system that draws on extensive research—both quantitative and fundamental—to separate the weak from the strong.

For Many Companies, Paying Down Debt Is Still an Option

It’s true that sharp increases in leverage at investment-grade companies over the past decade and challenges to firms’ business models have made many more vulnerable to downgrade.

But as we noted last year when downgrade fears were at a fever pitch, not all BBB-rated bonds are created equal. Sure, companies that responded to pressures in their industries by pursuing leveraged mergers and acquisitions—many food-and-beverage companies fit the bill—face significant fallen-angel risk today.

In many other sectors—energy, capital goods and basic industry, to name a few—firms still can clean up their balance sheets and pay down debt. GE, for example, is targeting aggressive debt paydown by selling off parts of its business. Other companies can prioritize debt reduction by reducing dividends and share buybacks. This flexibility should limit the number of bonds facing downgrades over the next few years.

Don’t Skimp on Credit Research

The market doesn’t always make these distinctions, and that presents opportunities for investors who do. Using our own internal ratings, we can isolate those investment-grade bonds that come with high-yield risk but investment-grade prices. The securities that fall into this category are the ones we consider most vulnerable to a downgrade.

On the other hand, bonds with strong internal ratings that the market is pricing as “junk” represent attractive opportunities with the potential to boost overall return.

This is important for all types of investors to know. For managers who are prohibited from owning high-yield bonds, avoiding the riskiest BBBs in today’s market should be a top priority. Since these investors must sell any high-yield credits, they’ll be better off unloading the vulnerable securities before the rating agencies act.

For investors who can hold high-yield debt, owning some angels after they’ve fallen may make sense. This is because fallen angels tend to enter the high-yield universe undervalued relative to their credit fundamentals and often end up outperforming original-issue high- yield bonds.

Of course, no investor should expect to be right all the time. Fortunately, there are other ways to hedge risk. For instance, investors may want to focus on shorter-maturity bonds, which will be more likely than longer-dated ones to outperform should they fall to high- yield status.

We expect concern about downgrades to wax and wane all year. It’s important not to overreact to swings in sentiment and the market. Increasing exposure to all BBB-rated bonds because they’re cheap by historical standards is just as risky as avoiding the market entirely for fear of downgrades. In our view, careful analysis is essential for uncovering value and raising overall return potential, no matter what your return objective or fixed- income strategy.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of AllianceBernstein nor TEXPERS, and are subject to revision over time.

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Lone Star State ranks 12 among best states to find a job

by Allen Jones, TEXPERS Communications Manager

If something can be measured, Texas often can be found near the top of national rankings.

Measured by land area, Texas is the second largest state in the United States. All that land is perfect for people to spread out in. With more than 29 million people, the Lone Star State also is the second largest ranked by population. All those people help make it the third best state to find a date. And, if you know a teenager, you may feel a bit better knowing they are more likely to be safe driving the roads of Texas. It is, after all, the fifth best state for teen drivers – meaning fewer fatalities and lower costs for car maintenance.

Texas is also one of the best states to find a job, according to a new report from the financial experts over at WalletHub. It ranked 12 out of 50 states. It isn’t quite the Top 10, but still isn’t bad.

In April alone, the U.S. added more than 263,000 new jobs, resulting in the lowest unemployment rate since December 1969. It makes for a tight labor market, but there are still places with plenty of jobs.

Source: WalletHub

WalletHub compared the 50 states across 33 key indicators of job-market strength, opportunity and a healthy economy, according to its website. The best state to find a job is Massachusetts, according to the WalletHub report, which gave the state an overall score of 71.88. It ranked No. 1 in Job Market and No. 16 in Economic Environment.

Texas received a total score of 60.10, just under No. 11-ranked Nebraska (60.33), No. 10-ranked Rhode Island (60.79) and No. 9-ranked California (60.84). Texas received a Job Market rank of 29 and an Economic Environment rank of 3 in WalletHub’s evaluation. Texas did rank first in a comparison of state with the Highest Monthly Average Starting Salary.

Lowest on the WallebHub report ranking states for jobs is West Virginia with a total score of 34.83. It received low scores in job opportunities, unemployment rate, and median annual income comparisons.

Learn more about WalletHub's listing:

Friday, August 2, 2019

Texas Pension Investment Performance Reviews: 

A Sign of Things to Come?

Editor's Note: Our friends at the National Council on Teacher Retirement, a nonprofit organization that supports retirement security for America's teachers, allowed TEXPERS to republish this column. To learn more about the council, visit

A new Texas law will require the majority of the state’s public pension funds to begin filing evaluations of their investment processes beginning in 2020. The analyses are to contain suggested improvements, as well. Will this be the start of a legislative trend that could extend nationwide?

The new requirement (Senate Bill 322) became law on June 10 and will currently apply to 65 of the state’s 99 public pension funds. They will be required to hire external firms experienced in evaluating institutional investment practices to review the system's investment practices, policies and performance in the previous year and to create a report with recommendations for improvement to be submitted to the Texas Pension Review Board no later than June 1 after the fund's prior fiscal year-end.

Plans with assets greater than $30 million will have until June 1, 2020, to submit their first evaluation reports. Thereafter, evaluation reports must be filed every three years for plans with more than $100 million in assets and every six years for plans with assets between $30 million and $100 million. Plans with less than $30 million are not subject to the new evaluation and reporting requirements.

Each evaluation must include:
  • An analysis of any investment policy or strategic investment plan adopted by the retirement system and the retirement system's compliance with said policy or plan
  • A detailed review of the retirement system's investment asset allocation, including the process for determining target allocations; the expected risk and expected rate of return, categorized by asset class; the appropriateness of selection and valuation methodologies of alternative and illiquid assets; and future cash flow and liquidity needs
  • A review of the appropriateness of investment fees and commissions paid by the retirement system
  • A review of the retirement system's governance processes related to investment activities, including investment decision-making processes, delegation of investment authority, and board investment expertise and education
  • A review of the retirement system's investment manager selection and monitoring process
The Texas Pension Review Board is then required to submit an investment performance report to the governor, the lieutenant governor, the speaker of the Texas house of representatives, and the legislative committees having principal jurisdiction over legislation governing public retirement systems. The report must compile and summarize the information received by them during the preceding two fiscal years.

The new law also requires Texas public pension funds list investment managers and provide direct and indirect investment fees by asset class in their annual financial reports, as well as post annual investment reports on a pension system's website or another publicly available site.

According to a recent article in Pensions & Investments (P&I), Texas State Rep. James Murphy, R-Houston, said he and the bill’s co-sponsor, Texas State Sen. Joan Huffman, R-Houston, introduced the bill to make it easier for the Texas Pension Review Board to make apples-to-apples comparisons of the investment health of the public pension plans it oversees. Murphy said this would give the PRB adequate data from each pension fund to identify plans that might be in trouble with regard to investment performance or funded status.

"Investment performance and benefit structures can become uncoupled leading to problems," Murphy said. He suggested pension plans would be able to "self-correct" problems using the suggestions for improvement provided by the external reviewers, thereby avoiding "the need for big brother to step in," he told P&I.

"What makes this law unique is the breadth of the regulation,” Leon F. "Rocky" Joyner, Atlanta-based vice president and actuary, public-sector retirement practice leader, with Segal Consulting, told P&I. “While many elements were already covered in GASB 67/68, the level of detail required for commissions and fees sets a new level of disclosure standards."

Finally, the new law allows a pension system to engage a firm with which it already has a relationship, such as an investment consultant, to prepare the fund evaluation. However, it expressly forbids hiring firms that directly or indirectly manage money for the fund.

Generally, reaction to the new requirement has been neutral to leaning positive. The City of Austin Employees' Retirement System "supports the bill's transparency requirements and the focus on fiduciary standards," and Tim Lee, executive director of the Texas Retired Teachers Association (TRTA), told P&I that requiring these plans to submit these evaluation reports “may help identify potential problems," particularly with regard to the many smaller pension funds in Texas, and allow action to be taken if necessary.

Furthermore, most of the large Texas public retirement systems already capture the investment information mandated by the new law, and some said they might use their existing investment consultants to prepare fund evaluation reports.

For example, Brian Guthrie, executive director of the Teacher Retirement System of Texas, told P&I it "won't be a big lift" for his system, noting most of the required information already is being collected by the pension fund and the system's consultant, Aon Hewitt Investment Consulting, as part of regular reporting. Keith Yawn, director of the office of strategic initiatives at the Employees' Retirement System of Texas, also said "there won't be a lot of change" to what the fund already reports.

However, plans are required to pay an evaluation firm, so the cost burden on smaller plans may be high, warned Christopher Hanson, executive director of the City of Austin Employees' Retirement System. Although his fund already collects the vast majority of what the legislation requires, Hanson said having the fund's investment consultant gather required information and evaluate the system's operations will cost about $40,000. And this cost would be even higher if the plan hired another consultant, which would need more time and labor to study the system, he explained.

Will the Texas legislation serve to spark similar action in other states? P&I says Texas is the only state to mandate detailed reporting on the public pension fund investment except South Carolina, which enacted a similar law in 2017.

And there are other sources for reviews of such investment activities. For example, State Street Global Advisers did a report in 2018 on how public pension funds invest, looking at everything from local to global assets. The Pew Charitable trusts also did a review that same year of state public pension funds’ investment practices and performance.

However, Pew used their report to claim state retirement systems are becoming unsustainable, falling short of their investment targets and failing to put enough money aside to reduce liabilities. 

"Perhaps having these kind of analyses from our own systems might be a better approach," said Maureen Westgard, NCTR’s executive director. "However, if they are then used as the basis for prescriptive legislation, that will become a problem. Hopefully, the Texas approach can provide an example of the way in which plans can 'self-correct'."

But only time will tell. And in the meantime, be aware of this possible trend. NCTR will continue to monitor if there are any coordinated efforts to advance such legislation nationwide.

More information: Be sure to check out TEXPERS Pension Observer, our membership magazine, to read more about Senate Bill 322 and another bill that could impact Texas pension systems. The story starts on page 6.

    Thursday, August 1, 2019

    State policies govern pension plan participation by charter school employees

    In Texas, employees of open-enrollment charter schools are eligible for membership in the Teacher Retirement System of Texas.
    "States differ regarding their inclusion of charter school employees in public pension plans," according to a July 31 tweet by the National Association of State Retirement Administrators. "In some states, it is mandatory that these employees participate in the state system while in other states, it is available as an elective option."
    In Texas, state law requires mandatory membership in TRS if an employee of an open-enrollment charter school is working in a full-time position.
    Click here to compare other state policies governing pension plan participation by charter school employees in a document compiled by NASRA.