Commentary: Plan sponsors, do you know your credit risk?

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.

A key advantage of the dual portfolio framework is that it is not a one-size-fits-all model. Given the nuanced but distinct differences between plans, this is an important feature. Certain plans are more cut and dried in their approach to risk. Endowments and foundations view fixed-income assets primarily as an "anchor to windward;" public pension funds consider long Treasuries as a left tail or crisis hedge, and private foundations are focused on meeting the IRS' minimum 5% distribution requirements plus inflation. More customization, however, may be required for a multiemployer plan, which may demonstrate relatively high negative cash flow. A risk-mitigating portfolio in this scenario can balance near-term payments and longer-term goals. A property and casualty insurer, on the other hand, will generally position its risk-mitigating portfolio as a hedge against their liabilities and deploy its return-seeking portfolio to maximize the value of surplus assets.

The point is that a broad-based allocation to fixed income, such as a portfolio that resembles the Bloomberg Barclays U.S. Aggregate Bond index, is often too blunt of an approach to meet these unique demands even though it's appropriate for more traditional investors. Consider, for instance, that the duration of a fixed-income portfolio that mirrors the aggregate index has a duration of roughly six years — far shorter than the typical pension liability and, in some cases, far longer than the requirements of a typical property insurer.

Another drawback of the aggregate bond index or a similarly constructed fixed-income allocation is the negative convexity. These characteristics stem from exposure to the callable features of certain corporate bonds or securitized loans (such as mortgage-backed securities and commercial mortgage-backed securities). The Bloomberg Barclays U.S. Aggregate Bond index, for instance, can be split roughly 50/50 between callable and non-callable bonds, meaning that when plans most require protection — as interest rates fall — the fixed-income basket actually gets weaker.

This is because bonds are likely to be called or prepaid, which produces a dynamic in which the more interest rates decline, the slower the price of callable bonds increases (creating a negative convexity that contrasts with the behavior of Treasuries in a similar scenario).

Treasuries, on the other hand, exhibit positive convexity, providing plans with a win-win scenario in which the more rates decline, the faster Treasury prices increase, and conversely, the more rates increase, the slower prices decrease.

In a year in which the Federal Reserve has vacillated between raising and lowering rates, a dual portfolio framework, or the risk-mitigating portfolio in particular, benefits from addition by subtraction. Through customizing exposures vs. mimicking the more comprehensive Bloomberg Barclays U.S. Aggregate Bond index, the dual portfolio framework effectively allows plans to avoid or minimize the proportion of callable bonds in their fixed-income allocation or structure the portfolio with a duration profile that avoids the "belly of the curve."

Starting in 2007, when the Fed first began lowering rates, and the seven years that followed in which rates remained near zero, plan sponsors have struggled to find reliable and adequate yield. This has driven investors to overweight credit to compensate for the shortfall. Corporate balance sheets, given the low cost of debt, have also taken on increasing levels of debt, often to help fund share buybacks or dividends. As of Jan. 1, S&P Global tallied $9.3 trillion in outstanding U.S. corporate debt, over a quarter of which S&P cited was speculative-grade debt. The impact, as mentioned, has been far more exposure to credit risk than most plans may recognize.

Thus, the equity and bond portfolios are simultaneously exposed to correlated equity and credit risks. To avoid or mitigate this "doubling down" effect, the dual portfolio framework simply allows for a more deliberate approach to credit decisions. More specifically, it separates the choice to take on interest rate exposure from the credit risk embedded in equities or bonds.

Plan sponsors are always thinking about risk and outlining a whole range of market scenarios that could affect their ability to fund existing and future obligations. Oftentimes, however, plans won't consider a liability-driven investing strategy until the risks of not doing so become more acute. Many, for instance, are unwilling to lower their return targets believing they may be leaving money on the table in rotating to fixed income from equities. Others believe that a risk-mitigating portfolio implies owning long-duration bonds. Both misgivings, however, overlook derivative/overlay strategies to increase the hedge ratio while maintaining long-term return objectives. They also fail to consider that a dual portfolio framework can open the door to more dynamic hedging strategies while tracking performance through customized benchmarks.

Ultimately, though, it's about understanding the mission of the organization, the unique objectives and challenges to fulfill it, and the role and ability of the investment program to meet the organization's long-term goals. A dual portfolio framework, through providing transparency into credit risk; allowing plans to steer clear of fixed-income investments that don't provide protection in a bear market scenario; and allowing for customization based on a plan's specific needs and obligations, can provide comfort for plans even against an uncertain backdrop.

Gordon Latter is a principal and consultant at Meketa Investment Group Inc., Chicago; Timur Kaya Yontar is a senior vice president in Meketa's consulting and research group, Boston; and Frank Benham is a managing principal and director of research at Meketa, Boston. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.