Senior secured loans can offer diversification, rate protection, yield for cash balance plans
As cash balance plans have experienced a rise in popularity, the search for optimal investment allocations has continued. As noted in the article “Cash balance plans gain favor as option among public pension funds” (Pensions & Investments, May 28), public pension funds are now following corporate pension plans down the cash balance path. According to the Bureau of Labor Statistics, about one in three private industry employees covered by a defined benefit plan is enrolled in a cash balance plan. While the devil is in the details, we believe many investment allocations for cash balance plans are not ideally aligned with the nature of the cash balance liability.
While traditional defined benefit plans accrue retirement benefits to be paid as a series of monthly payments beginning at retirement, cash balance plans are individual retirement accounts with a stated balance that ultimately will be paid out as a lump sum or a lifetime annuity. This stated balance is typically composed of annual “pay credits” from the employer along with an “interest credit” based on either a fixed or variable rate.
Most of the differences among cash balance plans relate to the choice or calculation of the interest credit. Fixed-rate interest credits are now less prevalent than floating-rate interest credits. An example of a commonly used floating-interest credit is the 10-year Treasury yield. The individual account would be credited annually based upon the prevailing 10-year Treasury yield at the beginning of each year. It is vital to note that based on these pay credits and interest credits, the account balance of cash balance plans can only increase over time. The economic liability of the plan cannot be hedged with traditional tools from the sponsor's perspective. The goal of the asset allocation and investment decisions, therefore, is to achieve an annual return that matches or exceeds the interest credit rate while protecting principal.
Cash balance plans are best served by a diversified investment portfolio that achieves an annual return that matches or exceeds the interest credit rate. Investments that provide appropriate returns should avoid interest rate risk because there is no liability match.
One investment that is well suited for cash balance plan allocations is senior secured loans. They provide significant current yield, have virtually no interest rate risk and benefit from seniority within the capital structure.
Senior secured loans have experienced strong growth over the past two decades, both in terms of new issuance as well as the number of investors and market makers, resulting in a large and highly developed institutionalized market. Even though these loans are issued by below-investment-grade companies, they are senior in the company's capital structure and secured by the assets of the corporation. In addition, loans provide further protection to investors through financial covenants, potentially keeping recovery rates high. Loan prices were stable pre-crisis and are less sensitive than other debt instruments to interest rate movements because of their floating-rate coupon payments (they are consequently viewed as an effective inflation hedge). These senior, floating-rate corporate loans are commonly issued by below-investment-grade companies for the financing of acquisitions, capital expenditures and general operating purposes.
Given there is no discounting of pension liabilities to match investment portfolio values as in a traditional corporate defined benefit plan, there is no incentive for cash balance plans to take undue interest rate or duration risk. Senior secured loans, given their floating-rate nature, have virtually zero price sensitivity to changes in interest rates, yet offer the opportunity to achieve relatively high current yields in this interest rate environment. Loans, therefore, offer an opportunity to be an important component of the hedging portfolio of a cash balance plan liability. With loan yields in excess of 6%, the portfolio yield exceeds most interest credit rates in cash balance plans yet leaves the sponsor without the significant interest rate exposure that might be associated with other investment strategies, such as long duration credit, intended to achieve higher yields. The short-duration loan investment enables the portfolio valuation to keep up with the cash balance account valuation. There is virtually no risk of significant price depreciation due to large interest rate increases as in long-duration assets. In fact, a cash balance plan liability with an interest credit based on the 10-year Treasury yield cannot be replicated in an asset portfolio composed of annual investments in 10-year Treasury securities, given that the significant interest rate risk can drive a total return that is dramatically different from its yield.
Of course, as with all corporate fixed-income investments, there is the risk that the issuer defaults on its payment. Because the companies issuing loans are rated below investment grade, they possess higher probabilities of default than investment-grade companies. Default rates are cyclical and generally vary in tandem with the macroeconomic cycle. U.S. loan default rates peaked in 2009 at 9.6% based on the Credit Suisse Leveraged Loan index. Default rates on loans had fallen to 1.2% as of the end of the first quarter of 2012. Average default rates since 2000 are 3.4% while average recovery rates on loans, according to Moody's data, have been 80.3% between 1987 and 2011. These data imply average annual realized losses of 0.67% (3.4% default rate multiplied by the average loss of 19.7%). These realized losses are more than compensated by credit spread and current yield.
And naturally there is significant credit risk embedded in senior secured loans, it is vital to choose an experienced manager with robust credit and research infrastructure. In this interest rate environment, however, one may make the argument that understanding and analyzing credit risk from a bottom-up perspective is much more easily accomplished than predicting interest rate movements, given the myriad factors impacting interest rates. n
This article originally appeared in the October 29, 2012 print issue as, "Investing for cash balance plans".