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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
With the general rise in asset prices since the global financial crisis and the recent back-up in interest rates, UK pension schemes are at their healthiest aggregate funding levels for more than a decade. As a result, many schemes which previously weren’t in a position to de-risk now feel that the de-risking endgame is much closer. For most pension schemes, this involves increasing exposure to long-term credit. This can be either directly, through cash-flow-driven investing (CDI) strategies, or indirectly, via a buy-in or buy-out.
Earlier this year, I wrote about the de-risking dilemma: schemes are often looking to increase exposure to credit just when valuations are least attractive. This dilemma feels particularly acute today. However, I don’t believe it should prevent schemes from de-risking. Rather, I am encouraging schemes to consider their credit strategy so that they manage the credit spread exposure of their terminal portfolio while continuing to de-risk.
In my view, many schemes would benefit from acting now to take advantage of the relative attractiveness of short-duration credit. My analysis suggests that separating the de-risking triggers and management of credit exposure by using short-duration credit can help to protect schemes’ funding positions, ensuring they are prepared to move into longer-dated credit when spreads offer more attractive value.
Given the low yields and spreads currently on offer, our asset and liability management (ALM) model suggests that moving into shorter-duration credit can provide significantly more protection at current levels than purchasing longer-dated credit. Figure 1 shows the modelled impact on funded status from investing in short-duration and long-duration credit over three years (assuming 100% of scheme assets are invested and a fully hedged exposure to interest rates).
Clearly, long-duration credit displays an unfavourable risk/return profile compared with short-term credit.
This modelling highlights the potential for material losses in long-duration credit over the next three years, which helps to explain the caution I am currently seeing from many schemes. In long-term credit, expected excess annual returns are -0.5% in my base case, and the probability of experiencing negative returns over a three-year period is around 60%. Furthermore, the distribution of excess returns is negatively skewed, with a 10% probability that losses exceed 9%.
I expect shorter-duration credit to provide much better protection. Although it is currently yielding 0.5% – 1% less than longer-duration credit, I believe this lower yield is a small price to pay for the additional protection shorter-duration credit provides. In addition, some shorter-duration sectors offer higher yields, so judicious allocations to these sectors can be used to enhance the overall yield of the allocation.
While some schemes may need to lock in long-dated spreads now at any cost, many schemes which don’t need to do so are currently reluctant to move into long-duration credit at current levels, and our modelling supports this caution. Nevertheless, I believe that it is possible to add considerable value by adopting a considered, strategic approach, separating the decision to extend the credit spread duration from the decision to de-risk.
This approach has two aims: first, to protect the funded position through allocating to short-duration credit, thus making progress towards the de-risking objective; second, to wait for more attractive valuations before extending to longer credit spread duration and building the terminal credit portfolio. While long-duration credit may not look appealing at the moment, putting the strategy in place now will enable schemes to move quickly to take advantage of opportunities when they arise.