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Corporate DB Plans: Selectively Manage Risk and Adopt a More Defensive Playbook
The severity of the COVID-19 outbreak will continue to test markets. The recent US market drawdown stands out not only in terms of its absolute magnitude but also in terms of the speed at which it happened with the pandemic and an upended global energy economy serving as catalysts. Based on historic average monthly returns during sell-offs, the current drop is a clear outlier as moves of this magnitude and velocity were witnessed only during the downturn of 1987 and the crash of 1929. The pace is much more rapid than during the global financial crisis (GFC), when markets took 18 months to collapse from peak to trough. As we enter Q2 2020, we find many aspects of the investing world in conditions that have rarely been experienced, which continue to make liability and long-term investment based management a challenging exercise.
The S&P 500 Index plunged 32% in March as the longest bull market in history transitioned to a speedy bear market in just 16 trading days. As a result, volatility surged, and investors continued to seek liquidity for benefit payment outlays, rebalancing purposes and corporate finance cash needs. Whereas markets have sharply rebounded since the lows experienced in the middle of March, there has been very little faith in this rally as investors still lack clarity around the nature of the crisis vis-à-vis the duration and depth (eventual market bottom) of the sell-off. Although one can see across to the other side of the river, how deep the river itself is unclear (with respect to job losses, credit and earnings downgrades and defaults). While liquidity has improved due to unprecedented central bank and government interventions, it is too soon to call an all-clear on financial market functioning. Thus, economic forecasters and asset allocators are faced with two separate questions. The first question is about understanding how long the economic shutdown will last and how severe the immediate economic drag is going to be. The second one is regarding the time that would take before economic activity returns to normal. The answers on both fronts are challenging given lack of precedence. In this context, calling the absolute bottom is a fool’s errand as markets expect near-term volatility to continue.
As the current crisis continues to unfold, progress is made in combatting the virus and forthcoming economic data unfolds compared to what has been priced in, institutional investors may increasingly look at strategic ways of rebalancing or shifting their asset allocation in a gradual, cautious manner. Investors who have an intermediate to longer-term horizon may consider recent events as a buying opportunity. However, plan sponsors and investment committees need a strategy that is calibrated for the near-term environment of continued low interest rates and volatile risk asset markets. The high-quality nature of the discounting methodology for corporate defined benefit (DB) plan liabilities has meant that liability values have risen as risk assets, especially equities, have fallen. Wider credit spreads over the period dampened the blow, but falling Treasury rates and greater drops in equities meant assets did not keep pace with liabilities. This has translated into an erosion in funded status year to date with plans that are more heavily tilted toward return seeking assets (equities in our illustration below) seeing greater degradation.
In times of crisis and limited clarity, particularly during recessionary periods, the best course of action is to selectively manage risk and seek return using a more defensive playbook, across and within asset classes. A consistent theme across our asset allocation teams and our clients, both discretionary and non-discretionary, has been to seek capital efficiency within a fixed-income portfolio and risk efficiency within riskier, growth-oriented assets, notably, global equity allocations. This approach proved to serve clients well throughout the recent crisis. Lower-beta equities (low volatility, minimum volatility and defensive equity) have meaningfully outperformed their cap-weighted benchmarks in the recent sell-off. Capital-efficient fixed income, longer-dated US Treasuries/Treasury Strips or, in synthetic solutions, US Treasury futures have helped provide a buffer to the widening in investment grade credit spreads.
A Potential Path Forward
While the path forward is clearly horizon based and driven by liquidity needs as we confront the crisis in our midst, we believe there are several ways in which clients can incrementally modify their approach to rebalancing or adjusting asset allocation targets depending on the nature of their liabilities or spending commitments.
While most corporate pension plans have adopted a dynamic de-risking glide path approach to managing their strategic asset allocation target weights, there are plans that have yet to embrace this approach within their governance framework. Certain pension clients with a codified risk framework experienced benefits over the past 1-2 years, having reached the funded status de-risking trigger. These plans incrementally shifted assets from return-seeking to liability-based fixed income. We have also advised plans to shift a greater portion of their assets to lower-volatility equity within their return-seeking allocation to de-risk within this asset bucket. In addition, to efficiently use their fixed-income allocation, we have advised to either increase their asset-liability hedge ratio (adding duration) with longer-term Treasury, Strips or synthetically via Treasury futures or maintain their hedge ratio while shifting capital to higher-grade corporate bonds that align more closely with their pension liability discount rate.
While the equity market may face challenges ahead, clients who retain a cautious outlook but seek to take opportunities to reallocate within their return seeking assets, either strategically or tactically, could consider higher-quality, lower-beta equity strategies. Heading into a recession, experience shows that defensive and quality assets provide advantages – defensive (those with lower volatility and beta to the market) and higher-quality stocks (those with higher profit margins, lower leverage and more stable earnings) outperformed during the past three recessions. Value stocks have done well, too, especially during the 2001 tech bubble.
A similar approach could be taken within the fixed-income portfolio allocation – considering opportunities in IG credit spreads. Owing to the speed of the downturn, the IG market suffered a record pace of downgrades and whether this is a repeat of the 2008 GFC remains to be seen. IG spreads initially quadrupled to over 400 bp, well above the 250 bp levels typical of recessions, but aggressive Fed actions calmed the markets, and IG has since retraced one third of the sell-off. The effectiveness of the Fed’s actions is also being reflected in narrowing dealer bid-ask spreads, moderating bond outflows and new issuances. We are watchful about other areas of potential stress – for instance, IG downgrades into high yield (HY) in 2020. If actual downgrades end up being significantly greater, credit markets could face far more downsides. The funding facilities that the Fed has announced include short-dated IG debt and fallen angels, which should dampen the impact of downgrades to HY.
Now that both the USD and EUR credit markets have de facto become monetary policy tools, we think credit markets have greater level of support than during the depths of the GFC in 2008. Spread movements, while painful on current allocations, may be indicative of stabilization as spreads have not widened to levels seen in the GFC. To be clear, although credit valuations may remain in recession territory for the next two quarters as uncertainty related to the spread of the coronavirus persists, we think the potency of the policy support greatly limits the scope for credit spreads to revisit historic crisis levels.
For corporate pensions, the desire to minimize volatility, however, often clashed with a desire to maintain high levels of pension income. The most common objection against the ‘de-risking’ arguments was the opportunity cost of moving from equities to high-quality, long-duration bonds. The nature of the trade-off has changed in the current environment. Clients continue to face the prospect of meeting liability hurdles or spending policies and lower-volatility equity and yield related needs will drive capital into companies with strong dividends and a capacity to maintain higher-quality balance sheets and earnings profiles. We believe even modest allocation adjustments that seek quality and lower volatility within global equities and higher-quality IG US corporate fixed income could provide incremental risk-adjusted return benefits for longer-term investors.
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