STAMFORD, Conn. - International Paper Co.'s pension fund has extended the duration of its $1.2 billion developed-markets fixed-income portfolio in an effort to better match its assets with its liabilities.
Using an overlay strategy, the $5.6 billion pension fund has increased the duration of its bond portfolio to 10 years from four in a way that loosely matches International Paper's retiree liabilities, said Robert Hunkeler, vice president-investments. The fund hired BlackRock Inc., New York, and NISA Investment Advisors LLC, St. Louis, to implement the strategy, primarily through the use of interest-rate swaps.
IP is in essence using a surplus management technique. Such strategies, born in the late 1980s, are experiencing renewed interest now that many plan sponsors are faced with underfunded pension plans for the first time in years. Asset-liability matching strategies can help pension funds reduce the odds of having to make hefty and unwelcome contributions.
"Everybody's talking about surplus management and surplus volatility," said Jeffrey B. Saef, senior vice president at Boston-based Putnam Institutional Management's strategic relationship team, which consults with major pension fund executives.
Michael Peskin, head of the global asset-liability management team at Morgan Stanley & Co. Inc., New York, said plan sponsors want to take risk off the table. He said they are exploring three ways of doing so, in declining order of acceptance: extending the fixed-income portfolio duration; reducing overall equity exposure; and putting collars on equity exposure.
To date, however, there are few takers. Low current interest rates, the loss of upside potential and the inability to have a big enough effect on the total pension fund are mitigating factors, said Michael Hall, consultant at the Frank Russell Co., Tacoma, Wash.
On the long-duration strategy, pension executives basically divide into two camps. Some, like IP's Mr. Hunkeler, believe the yield curve is so steep now that they are unlikely to lose money from a rising rate environment. "We would need a rather large rise in interest rates before a switch to long bonds would be a worse decision," he explained.
By investing through swaps that serve as a proxy for corporate bonds, Mr. Hunkeler said he is able to take advantage of the huge spread that has opened up between corporate bonds and Treasuries. That spread, which pays investors for the risk of corporate defaults, would shrink if the economy were to rebound and the yield curve were to flatten.
Other executives, however, think there is too much risk of long-term rates going up, thus pounding the value of their portfolios. Bond prices move inversely to yields. Instead of pursuing asset-liability matching strategies, some are shortening the duration of their portfolios as a strategic bet on interest rates. Mr. Peskin said many pension executives are waiting for interest rates to rise or their funded status to improve.
William F. Quinn, president of AMR Investment Services Inc., Fort Worth, Texas, said he has halved the duration of American Airlines' $2 billion fixed-income portfolio in the past 15 months. For American Airlines Inc., whose $5.3 billion pension fund is overseen by AMR Investment, that meant slashing the average duration to about 13 years, still long for most pension funds.
The duration chop effectively reduced the fund's hedge from 100% to the 50% to 60% range, he said. "Given how low interest rates are, we think that's a very prudent thing to do."
The American Airlines fund, which has had a long-duration bond portfolio in place since 1979, invests in physical instruments instead of derivatives, traditionally in zero-coupon Treasury and agency issues. In its recent shift, however, American switched primarily to corporate bonds, picking up some 150 basis points in yield in the process.
Joseph Nankof, principal, Rocaton Investment Advisors LLC, Darien, Conn., who advised International Paper on the strategy, said every client has different liabilities and issues. "Some would say that extending duration makes sense or reducing duration makes sense. Some would be tempted to reduce duration because they believe interest rates will increase going forward," he said.
Barbara Novick, managing director at BlackRock, said pension executives are asking about extending duration as a way of matching assets to liabilities. But she is also getting queries on shortening duration as a bet on interest rates. She said the firm is receiving far more inquiries than usual for customized approaches.
For International Paper, there were several reasons to use an overlay strategy.
For one thing, IP unitizes the asset classes of its defined benefit plan, enabling its defined contribution plan to invest in parallel. By using an overlay, IP is able to extend the duration of the defined benefit plan's bond portfolio without changing that of the defined contribution plan. The duration is pegged to the Lehman Brothers Aggregate Bond index.
For another, the overlay process does not disturb International Paper's underlying bond portfolios. Four managers run about $950 million in domestic bonds: BlackRock; J.P. Morgan Fleming Asset Management; Western Asset Management Co.; and Pacific Investment Management Co. Fischer, Francis, Trees & Watts and PIMCO collectively manage about $225 million in international fixed-income assets.
A third factor is that liquidity of long-term corporate bonds is very limited. By investing in the long-maturity swap market, investors obtain more liquidity, said Mr. Nankof.
International Paper has established a customized benchmark for the overlay, consisting of equal parts of the 10-, 20- and 30-year swap indexes. Currently, that benchmark has a duration of 11 years.
Mr. Hunkeler said the notional exposure of the overlay portfolios totals $655 million, allocated evenly to BlackRock and NISA.