In addition to traditional fixed income investments in government and corporate bonds and money-market securities, this category includes absolute return strategies such as hedge funds and currency hedges. We include absolute return strategies in this asset class because they provide steady income, similar to fixed income securities, but with an additional risk allocation aimed at adding value above the benchmark.

Our debt portfolios also seek new opportunities for diversification, often using such non-traditional investments as derivatives and securitized pools of assets. For example, indexes of credit default derivatives, which reference 100 to 125 actively-traded individual corporate credits, are now highly liquid instruments and are used extensively by banks and institutional investors for both investment and hedging purposes. With this increased liquidity, we often have better pricing information through derivatives than in traditional cash bond instruments.

Securitized pools of assets have also become important instruments in the debt markets. Some of these instruments were backed by subprime mortgage pools; however, other sectors such as bank loans, auto loans, credit cards and commercial mortgages also have been pooled and packaged as a new set of securities. To provide alternative sources of diversification, we hold these other asset-backed securities pools in our fund.

Investments in securities backed by subprime mortgages grew very quickly around the world during the last three years. A lack of investment discipline and poor due diligence allowed them to be treated as high-quality securities from a credit perspective. Because there was little information available regarding the quality of documentation and controls over loan approval processes, these securities did not meet Teachers’ investment requirements. But when their inherent risks became widely known, there was a pervasive negative fallout on the credit markets in general due to the widespread use of securitized pools of mortgages to support credit rating upgrades. When the underlying value of these pools of assets dropped significantly, they could no longer support the credit ratings of these securitized vehicles.

The rise in risk premiums in the general credit markets also had a negative impact on the value of our debt holdings, other than G10 sovereign debt. In particular, holdings in sectors such as commercial mortgages, leveraged investments in investment vehicles that in turn held securitized assets (including those related to credit card debt, auto loans, bank/finance sector debt and residential and commercial mortgages) experienced mark-downs in 2007, which are reflected in the rate of return for this asset class. The marked-to-market effect of the breakdown of global liquidity had a material impact on our 2007 performance. We expect we will see further impacts as the market continues adjusting to this phenomenon.

In future, all investors can be expected to insist on full transparency by the sellers of these instruments. This will allow investors to evaluate credit impacts of all important sources of risk. We continue to use these non-traditional investments only where full information is available to allow us to evaluate the exposure, without reliance on rating agency or other external assessments.

Bond and money-market holdings
These assets totalled $6.4 billion at year end compared to $6.2 billion at the end of 2006. The debt on the plan’s real estate assets, valued at $2.9 billion at year end, compared to $3.4 billion in 2006, is subtracted from the fixed income asset class. Investment income from money market and bonds totalled $1.2 billion in 2007.

In addition to Canadian and U.S. government bonds, we had $1.4 billion in credit-linked portfolios at year end compared to $0.8 billion in 2006. This includes increased emerging markets exposure that we have been accumulating over the past three years. We use these strategies to diversify our bond portfolio, adding to the tools we use to enhance returns overall in the fixed income asset class.

Absolute return strategies
Absolute return strategies and hedge funds totalled $12.3 billion at year end compared to $15.3 billion at December 31, 2006. The goal of these strategies is to generate positive returns regardless of movements in the broad markets. Some of these investments use little net capital as they employ a balanced combination of long and short positions on instruments, companies, industries or investment styles. Some aim to capture tactical opportunities to extract extra returns from under- or overweighting various asset classes.

Our investments in externally-managed hedge funds and hedge fund strategies totalled $9.9 billion at year end compared to $9.7 billion at the end of 2006, and added $70 million of value during the year. Managed both directly and in fund-of-funds structures, this portfolio is designed to earn consistent market-neutral value-added returns while diversifying risk across many managers and multiple strategies and styles.