The historic relationship between fixed income and equities has been put to the test in recent years. Since 2005, for instance, the correlation between investment-grade spreads to equity returns has exceeded 70%, while high-yield spreads showed even more correlation to equities, surpassing 80% over the same time period. This may not seem like it matters in the 10th year of an extended bull market, but when the cycle does turn — exposing institutional investors to risks that transcend both the equity and credit markets — those who haven't adequately diversified may be more exposed than they realize. This is particularly the case for plan sponsors that have overweighted their allocations to credit in search of additional yield. These adjustments, which may be tactical in nature, come at the expense of the hedging characteristics that would traditionally make fixed income appealing amid the later stages of a cycle.
In many ways, the challenges today are no different than the challenges faced by investors throughout time. Investors simply have to find the optimal trade-off between maximizing their long-term returns while accounting for the most prominent near-term risks. Plan sponsors have the added complexity of managing other considerations such as spending needs, liquidity and solvency requirements, which only become that much more difficult to map out amid interest rate volatility.
A dual portfolio framework, one that seeks to recast existing positions into either risk-mitigating or return-seeking portfolios, can allow plan sponsors to customize their strategy based on their unique profile. It also facilitates a better understanding of the overall credit risk (across bonds and equities), while allowing plans to avoid specific fixed-income securities and strategies that might upset the balance of their desired risk tolerance.
A return-seeking portfolio, as the name implies, seeks to maximize performance through tilting exposures toward equities and other high-risk, high-reward securities. A risk-mitigating portfolio, alternatively, will invest in strategies that provide protection against equity market downturns and widening credit spreads. It could encompass long-duration fixed income, alternative risk premium, managed futures and tail-risk hedging strategies. But the objective, even in a worst-case scenario, is to obviate the need for cash contributions to meet future obligations.