It's been a good year for corporate pension funds. Based on our estimates, average funding ratios are at their highest levels since the global financial crisis, thanks to market movements and plan contributions — including those spurred by last month's tax-incentive deadline.
Now, after being on pause for a few years, many plan sponsors find themselves in a position to put the theory of derisking into practice. As they do, here are three things they should be mindful of:
1. There's no free lunch when using unfunded duration.
Plan sponsors contemplating ways to get the most duration exposure for their incremental dollar need to understand the less obvious costs embedded in each alternative. For example, consider Treasury futures, standardized contracts that generally expire quarterly. A host of factors can affect their performance relative to the performance of cash Treasuries, including the "roll costs." Investors typically roll their contracts prior to the delivery month to avoid the risk of physical settlement and pay a premium to do so — the result of a supply/demand imbalance. In recent years, there has been significant demand for long positions in futures from pension funds and insurance companies that have long-dated liabilities to hedge, but the number of natural sellers of unfunded duration is limited. It is up to arbitrageurs to fill the gap, a process that is not riskless and may use scarce resources such as repo lines and balance-sheet capacity. The compensation for the arbitrageurs to use these resources is reflected in the roll costs, which can vary considerably over time, particularly for plans looking to roll large positions.
Other tools, such as interest-rate swaps, also involve costs and risks that aren't obvious up front and should be thoroughly evaluated when constructing a liability-hedging strategy and determining the extent to which unfunded duration will play a role. One alternative for plan sponsors to consider is Treasury STRIPS, as they can potentially provide a relatively simple, capital-efficient and cost-effective means of extending duration. Ultimately, the size of the capital allocation to liability-hedging assets, the desired duration target and the dollar size of the notional exposure are among the factors that will influence how a plan should construct its hedging strategy.
2. The credit markets might not be as risky as they look
The share of BBB-rated bonds in the investment-grade corporate bond market has grown substantially — to 48% of the Bloomberg Barclays U.S. Corporate Bond index in June 2018 from 33% a decade earlier — prompting some to question whether the market has become meaningfully more risky. We don't think so, but we do believe it's important for plans to understand the drivers behind this trend. For example, the lion's share of the increase in BBB bonds has come from the financial sector. After the global financial crisis, credit ratings of many large banks were downgraded due to concerns about their capital market operations and uncertainty over future government support. But since then, we've seen evidence that large banks, broadly speaking, have improved their credit profiles (e.g., bolstered capital buffers), and in fact, we would argue that this segment of the market has better credit fundamentals today than when it had higher ratings a decade ago.
Amid the concern about BBB bonds, some plan sponsors have contemplated using quality-constrained benchmarks to limit credit risk in their portfolio's liability-hedging allocation. However, we think this approach could have unintended consequences. Namely, it would eliminate a significant portion of the market from the opportunity set, which could lead to more issuer concentration, exposing a portfolio to greater idiosyncratic credit risk. Instead, we think plan sponsors may want to consider three ideas:
- Construct a diversified corporate credit portfolio, inclusive of BBBs, to potentially expand the opportunity set and reduce issuer concentration.
- Blend this diversified portfolio with U.S. Treasuries to arrive at a credit quality in line with the discount rate and to potentially enhance liquidity.
- Seek fundamentally driven approaches that aim to identify stable and improving credits while helping to mitigate the impact of negative credit events.
3. Derisking doesn't just mean buying long bonds
Plan sponsors often ask what else they can do to help limit funding-ratio risk without sacrificing too much funding-ratio growth potential. We think this highlights a gap between the traditional equity and long bond components of a plan portfolio. The equity allocation seeks to grow the plan's funding ratio but at the same time subjects it to drawdown risk if equities perform poorly (especially if those negative equity returns are coupled with lower rates). And the long-bond allocation aims to stabilize the funding ratio but doesn't help it grow.
We think there are investments that may help bridge this gap — sitting within the return-seeking portfolio but potentially playing a dual role of providing downside risk mitigation in times of funding-ratio stress while still participating in up markets and contributing to funding-ratio growth in better environments. The focus should be on strategies that may offer some combination of low equity beta and/or moderate interest-rate sensitivity (duration). Examples include strategies focused on infrastructure investments, income-oriented equities, low-volatility equities, long/short equity investments and fixed-income credit sectors.
In our estimation, replacing some traditional equity exposure with these types of strategies may have the same potential to reduce funding-ratio volatility as reallocating a portion of assets to long-duration bonds, but with greater potential to improve funded status. This could be a stand-alone first step toward derisking or part of a broader strategy that aims to pull multiple levers to derisk.
Amy Trainor is LDI team co-chairwoman, portfolio manager and multiasset strategist, and Connor Fitzgerald and Allan Levin are fixed-income portfolio managers at Wellington Management, Boston. This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.