Investors building LDI portfolios face not only a limited supply of long-term, high-quality corporate bonds, but also a challenge from the high level of concentration among a small number of companies and industries.
LDI investors need to cast wider net
Concentration of bonds in few sectors complicates portfolio structure
While the shortage of quality bonds is well known, an analysis by Pensions & Investments shows that eight companies account for more than 80% of corporate bond issues that meet P&I's definition of “long-term, high-quality” bonds (see accompanying methodology.) Those findings highlight the challenges LDI investors face when building a diversified bond portfolio across multiple companies and industries.
The analysis found only $101 billion in outstanding bonds rated AA- or higher matched P&I's criteria, while the largest pension funds now pursuing LDI strategies likely will need approximately $275 billion, according to P&I estimates.
In a 2010 white paper on implementing a liability-driven fixed-income portfolio, ING Investment Management states that investors “need approximately 100 issuers, in multiple industry groups, to achieve diversification sufficient to mitigate issuer-specific credit risk.”
Bob Kase, senior portfolio manager at ING in Atlanta, said in a telephone interview that the shortage of high-quality corporate bonds available to LDI investors is something he discusses with current and potential clients all the time. He did, however, discuss a number of ways to navigate the shortage of long-term, high-quality corporate bonds, including expanding the investing universe to the entire corporate bond index. The problem with this approach, he said, is that investors get a lot of securities they do not want, and the duration is typically half of what they need.
Mr. Kase also suggested the use of Build America Bonds, taxable municipal bonds created in the 2009 U.S. economic stimulus bill, but noted the pool of available securities is simply not big enough for the LDI market.
Lastly, he said investors could use derivatives, although the most liquid credit default swaps have an average duration of five years, while the average pension plan's liability duration is 12 years. He noted that investors can use leverage to get that type of duration, but such a move introduces volatility into the portfolio.
The most effective way to navigate the shortage of high-quality, long-term corporate bonds is to open up the investing universe to BBB credit ratings, Mr. Kase said. This wouldn't be a means of chasing higher yields and alpha generation, but of achieving diversification across companies and industries. Doing so, however, emphasizes on industry analysis during the security selection process, as companies with lower credit ratings in volatile and cyclical industries should not be included in an LDI portfolio, according to the ING white paper.
“LDI is dynamic; your investing universe is limited so you have to find a way to dynamically manage around that universe without dramatically increasing your risk,” Mr. Kase said.
David Wilson, managing director of LDI at Cutwater Asset Management, Armonk, N.Y., also suggested that LDI investors “shouldn't only stick to AA bonds.” He believes “there is a lot of value out there in A to BBB bonds.”
In a telephone interview. Mr. Wilson noted he has not yet seen the shortage of high-quality cash bonds dramatically affect the current LDI environment, primarily because there are two drivers preventing investors from adopting the strategy: low pension plan funding ratios and low interest rates.
As interest rates rise and plans improve funding ratios and subsequently move away from an equity-centric investing approach, Mr. Wilson believes the market for high-quality corporate bonds will be squeezed — but will create supply as “issuers will see it as a good opportunity for long-term financing.”
Aaron Meder, head of U.S. pension solutions at Legal & General Investment Management America in Chicago, also stressed the need to expand the investing universe. He noted that although plans are required under accounting rules to discount plan liabilities using market yields on high quality bonds (rated AA- and above), investors should build the core of their LDI portfolios focusing more on the discount rate methodologies outlined in the Pension Protection Act of 2006, which are more closely tied to A to AAA rated bonds, with a small allocation to BBB issues.
“We would absolutely not advocate building an LDI portfolio using only AA and higher securities. There's too much concentration and not enough diversification,” Mr. Meder said.
He added that despite how the discount rate is calculated, pension liabilities do not have default risk. It is therefore important to build an LDI portfolio that is “risk-focused, with the objective of avoiding downgrades and defaults and minimizing drag relative to the liability.”