Following a 40-year bull market in fixed income, investors are now immersed in a new world in which yield is obtainable. Investment grade all-in yields have risen to 5.3% — the highest level since 2009 — and speculative grade all-in yields are at a healthy 8.5%.1
However, it’s worth considering that the end of the credit cycle is drawing nearer. While the timing is unclear, rates are poised to retrench (see: 2023 GMO | Bonds Are Poised for a Turn.) In addition, structural forces such as aging demographics, slow productivity growth and disinflation from COVID-era peaks are set to put downward pressure on rates. Already, all-in yields have dwindled since the fall of 2022. The curve has remained inverted given CPI surprises and a Fed that has not yet reached peak Fed Funds (although they are getting close).
For pension plan sponsors, this means that they are entering a new environment with funding status strained. Already, the corporate pension plan funded status was at 109% in January 2023, versus the 2022 high of 113% last November.2 With a potential equity earnings recession, plans could face a double whammy of lower equity asset values and lower yields. (A decline in yields would likely increase the value of liabilities more than assets, as liabilities tend to have a mix of assets, including equities and fixed income, while liability values are based on long duration high quality corporate discount curves.) Notably, even if equities have banner performance and growth asset prices rise, the funding headwinds could persist. In this piece, we explain why a capital efficient approach is a compelling way to increase the allocation to growth assets and hedge this gap.
As plans progress down their de-risking glidepaths, an important objective is to hedge both the duration and credit spread exposures inherent in plan liabilities. And these exposures are substantial; for example, a hypothetical pension plan’s liabilities may exhibit 14 years of duration, while assets have only 6 years. While many plans have already transitioned from US Aggregate (6.4 years of duration) to US Long Government Credit (14.5 years) or similar,3 these plans still embed a significant unhedged risk: If 40% of plan assets are invested in Long GC products, this still leaves a 8-year underweight duration position at the plan level (or even longer if a plan is underfunded). This inherent 8-year duration “bet” is meaningful. For now, this bet is paying off; investors can find juicy yields in even high-quality sovereign debt, allowing the funding status of firms to stay solid because of ample carry. However, with rates expected to fall, plan sponsors must ask: How can I protect my plan’s funding ratio against declining yields, and can I do so while conforming with my plan’s risk appetite?
Below, we outline two capital efficient LDI strategies for consideration in today’s market environment.
For plans that are de-risking, rather than simply shifting assets out of their existing equities allocation to fund an increased long government/credit allocation, we suggest that they consider further extending the duration of their fixed income allocation using long STRIPS. This allows them to increase their hedge of liabilities without changing their overall asset allocation. In Figure 1, we change the composition of a hypothetical plan’s fixed income allocation from 40% Long GC to 20% US Strips 20+ year and 20% US Long Corporate — while leaving their 60% equities allocation untouched. We reference this portfolio as “Capital Efficient Portfolio 1”. This provides several benefits to the plan, including: an increase in fixed income duration by three years; virtually no give-up in expected returns, given today’s higher yields; and a projected meaningful decline in funded status volatility.
Introducing an equity allocation with less volatility (but comparable upside) provides similar benefits. The addition of a minimum volatility equity strategy greatly improves the efficient frontier of possible investment allocations. Our suggestion of increased allocation to long duration fixed income allowed for an improvement to the return/fund status volatility ratio. Adding a minimum volatility strategy, on the other hand, enables plans to further reduce funded status volatility while maintaining comparable return upside. This addition shifts the efficient frontier up and to the left. This happens because such strategies typically seek to provide market-equivalent returns over a full cycle by reducing market sensitivity and protecting against drawdowns, which can ultimately help to preserve a plan’s capital base. While the return outcomes are similar over time to market-cap weighted equity allocations, minimum volatility equities can greatly improve a plan’s ability to track liability returns because they reduce exposure to equity volatility.
Figure 1: A Capital Efficient Approach Can Provide a Wide Range of Benefits to DB Plans
In “Capital Efficient Portfolio 2” (Figure 1), we have examined the benefits of increasing allocation to long duration bonds, as well as introducing minimum volatility stocks. The grid illustrates the incremental benefit in the return over funded status volatility ratio when both concepts are introduced into the portfolio.
Every DB plan strategy should reflect the unique return goals, risk profile, and desired end game for the plan. We believe that many DB plans would greatly benefit from considering a capital efficient approach, which offers a greater ability to meet multi-faceted objectives. We’ve provided two examples of sample portfolios with duration extension and minimum volatility strategies. However, there are other capital efficiency strategies, including concepts for application in the not-for-profit space in which long duration assets hedge a substantial amount of equity beta risk. Here, the return of the negative stock/bond correlation may prove beneficial. These potential changes to a plan’s asset allocation can markedly improve its risk/return profile. In particular, a capital efficient approach could mitigate risks in an environment where bond yields could fall and equity markets remain volatile.
1 Based on the Bloomberg Intermediate Corporate Index, YTW, as of 02/15/2023, and the Bloomberg U.S. Corporate High Yield Index, YTW, as of 02/15/2023.
2 The Milliman Corporate Pension Fund Index.
3 As of February 8, 2023.
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