Pension funds that want to reduce risk in their portfolios should consider moving away from traditional core fixed-income strategies benchmarked to the Barclays Capital Aggregate Bond index, a paper from Cambridge Associates stated.
While many pension funds have remained steadfast to that index, the paper said, executives should instead embrace longer-duration strategies.
Moving to a longer-duration strategy reduces surplus risk, said Sona Menon, a Cambridge managing director and co-author of the paper.
“Essentially, surplus risk is the asset/liability mismatch in a pension plan,” Ms. Menon said in a telephone interview. “Most liabilities have a longer duration associated with them. Most plan liabilities will be in excess of 12, 13, 14 years. If you're invested in a short or intermediate — such as the Agg — duration, then the duration of that investment of five (years) falls quite short.”
Ms. Menon said Cambridge recommends extending the duration of the fixed-income portfolio to reduce that mismatch
She said the mismatch also means a portfolio based on the Barclays Aggregate index will underperform the pension fund's liability when rates fall, which they have done this year.
“If you're invested in the Agg, year-to-date your assets would be up 2.7% whereas if you were invested in long government/credit, you would be up 11.4%,” Ms. Menon said.
Finally, while conventional wisdom says longer-duration bonds would underperform if rates rise, Ms. Menon said this is not necessarily so.
“There's a certain amount of rate rise that's already priced in the market,” Ms. Menon said. “Long duration does not necessarily need to underperform short duration. By that I mean, if rates rise faster or at a higher magnitude than what's already priced in the market, then long duration would underperform.”
The paper is available on Cambridge's website.
