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Asset Servicing

Interest rate hikes could be boon for transition managers

David Wilson thinks transition managers could offer 'crucial' guidance to LDI clients when rates rise.

Transition managers are seeing a business opportunity in the potential for a sudden rise in interest rates in the next year.

A leap in rates could make some corporate pension plans with liability-driven investing policies turn to transition managers for investment shifts to fixed income from equities, sources said.

"A short-term jump (in interest rates) might mean that everyone will want to derisk at once, with as much as $1 trillion being derisked at the same time," said David Wilson, managing director, head of institutional solutions group, Nuveen Asset Management, Chicago. "That could be chaotic. Having a transition manager to provide guidance would be crucial."

Some market analysts are warning of a sudden jump in interest rates, although the Federal Reserve's latest forecast in June showed expectations of only a quarter-point increase from the current benchmark overnight rate range of 1% to 1.25% by the end of the year.

Former Fed Chairman Alan Greenspan in an Aug. 1 Bloomberg interview warned a bond bubble is lurking.

"By any measure, real long-term interest rates are much too low and therefore unsustainable," Mr. Greenspan said in the interview. "When they move higher they are likely to move reasonably fast."

That scenario, sources said, could mean a sudden rush among many plan sponsors to shift assets to liability hedging investments — chiefly long-duration corporate fixed income — from return-seeking investments when they reach a particular funded status or interest rate trigger point on their LDI glidepath. That rush could mean a shortage of available long-dated bonds, requiring other investments like overlays and derivatives that transition managers use.

Sources for this story said transition managers are preparing for such a possibility and talking with pension fund executives about helping them move assets when triggers are reached.

"There are about 22,000 corporate plans in the U.S.," Nuveen's Mr. Wilson said. "Look at those plans with more than $5 billion in assets and especially the megasize plans with more than $50 billion. If rates rise substantially and many of those large plans in LDI reach their triggers around the same time — say, leading to a 10% move from equities to fixed income — that would be a significant shift in assets and might require a transition manager. A plan with $100 million in assets can do it through their LDI manager and wouldn't be as hard to do.

"I can see a definite opportunity for transition managers if these conditions are met: the size of the plan is so substantial that a transition manager would be needed to transition from one asset class to another, and if rates were to rise quickly," Mr. Wilson said.

Paul Sachs, Philadelphia-based principal at Mercer Sentinel Group, the asset-servicing consulting business of Mercer LLC, agreed there is ​ "the potential" for transition managers to gain LDI-related mandates under those circumstances.

"LDI is not new news, but there's a wrinkle here," Mr. Sachs said. "There could be quite a groundswell in terms of derisking. I'm not clear if it will turn into transition manager mandates; in many cases, LDI transitions now are just cash redemptions from commingled equity funds to commingled fixed income. You would need triggers occurring at the same time among many plans, and then it would depend on the scale of the plans involved."

'Opportunity going forward'

Steve Kirschner, Seattle-based managing director, transition management, at Russell Investments, said he sees "an opportunity going forward" for transition managers in LDI. Russell, which provides both LDI consulting and transition management services, has seen assets moving into fixed income rise 75% as of July 31 from the same time last year, and while its clients generally have large allocations to fixed income, "a fair bit of that" is coming from plans with LDI.

Ben Jenkins, global head of transition management, Northern Trust Corp., Chicago, also said an increase in transition management for plans in LDI strategies "is relatively likely. There's precedent in the marketplace. In late 2015 and into 2016, a number of clients were doing exactly that. It wasn't just with Northern Trust, it was an industrywide situation."

Both Mr. Jenkins and Mr. Kirschner said a rise in Treasury yields, to 2.5% for 10-year Treasury bonds in early 2016 from 1.5% in late 2015, moved plans in LDI along their glidepaths.

"The problem then, and I would imagine it would be a problem today, is that the risk management spectrum is very different, making a larger risk spectrum to manage against," Mr. Jenkins said.

Maintaining a plan's risk profile during these transitions requires a look at the plan's overall investment portfolio, not just the assets being moved, Mr. Kirschner said. "You need to look at the overall intended exposure at the plan level," he said, paying attention to the asset shift in terms of beta across multiple asset classes.

Another issue with a sudden rush to fixed income, Mr. Jenkins said, is long-dated bond capacity. "It's not the risk of the asset, it's literally the amount of assets in the marketplace," he said. "If you have a large number of plans looking at long-dated bonds all at once, you get in a liquidity squeeze. Clients have to know they have to do this. There's a long checklist they go through before they transfer. Once they've done that, it'd be hard for a manager to say there's nothing in the market. Shifting to bonds will be more expensive to do."

Mr. Kirschner agreed that "in short bursts of time, there's a chance" of reduced availability of long-duration fixed income at a time when LDI-related demand would be high, "but we could see more corporations issue debt as a result. They tend to go hand in hand. There's often a natural balance between the demand for fixed income and the issuance."

Also, he said, plans moving to fixed income could use derivatives and overlays in the interim until long-duration fixed-income capacity improves.

Might not know it

It's possible that some transition managers who have been shifting plan assets to fixed income from equities could have done so for an LDI strategy and might not know it, said Zlatko Martinic, managing director, head of transition management, Penserra Securities LLC, Orinda, Calif. "Generally speaking, unless you know the client very well, you may not know if the transition you're doing is an LDI event," Mr. Martinic said. "If you were to assess all the assets that have been transitioned recently, the percentage that has been in LDI would be on the low end. But there could be those who have done this and they don't know it; the transitions can look like a traditional fixed-income transition."

Mr. Martinic said signs of an LDI transition are:

A large one-time shift between asset classes;

A shift to long-duration fixed income, both from equities but also from short-term fixed income; and

A large asset shift to Treasury inflation-protected securities.

"Transition managers who are aware of these coming transitions can step in efficiently, quickly and successfully," he said.