Why are some plans considering long-duration securitized assets for their LDI portfolios?
Amy Luberto: Long-duration securitized (LDS) assets may offer diversification versus corporate credit risk — and specifically, downside protection in a credit sell-off. The goal is for these assets to move similarly to the liability, as part of the liability-hedging portfolio, but at the same time, we don’t want them to move in the exact same way as corporate bonds in order to achieve some level of diversification. We think LDS may thread that needle pretty well, having historically had a fairly strong positive correlation with long corporate bonds in terms of both total returns and excess returns, while also leaving some room for diversification. In particular, LDS has tended to outperform corporate credit during spread widening events. We also believe that expanding the liability-hedging opportunity set with LDS can potentially help offset concentration risk in certain corporate indices and enhance credit quality and liquidity versus some corporate bonds.
Could private placements also play a role in diversifying LDI portfolios?
Amy Trainor: Private placements are typically investment-grade fixed-rate debt, issued across the maturity spectrum including at long durations — characteristics that may align with what plans are looking for in liability-hedging strategies. And I do believe that private placements can potentially play a role. But I’d also recommend that plan sponsors do their homework. For example, what are your expectations for a liquidity premium and how much risk are you willing to assume in pursuit of it? The yield premium over public corporate bonds can vary widely, depending on quality, risk profile, and subsector. In addition, how comfortable are you with a buy-and-hold position in an illiquid bond? Anecdotally, we’ve noticed plans targeting the 5- to 10-year maturity range in private placements, which might reflect liquidity concerns.
There appears to be growing interest in intermediate credit. What do DB plans need to know about this asset class?
Bill Cole: Interest in the 1-year to 10-year segment of the credit market has risen, particularly among closed and frozen plans. With liabilities that are shortening each year and liability-hedging allocations that are growing as a result of derisking, these plans find they have less need for capital-efficient sources of duration and spread duration to hedge their liabilities. Figure 3 shows how a liability-hedging allocation might evolve as the liability shortens over time.
For plans that have historically used long credit as the primary hedging allocation, there are a few noticeable differences within the intermediate segment of the market. For example, the intermediate segment is about twice the size of the long end of the market and it’s more liquid. As a result, transaction costs may be more manageable. The sector composition of the intermediate market is also quite different, with more exposure to banks and less to utilities, for example.
I’d also note that there are differences between the intermediate credit and the intermediate corporate indices. The intermediate credit index includes the government-related sector (e.g., sovereigns, supranationals, and taxable municipals). This sector is not represented in most plan discount rates, which is why we think an intermediate corporate index may be a better liability hedge.
Finally, within an intermediate allocation, we think that expanding the opportunity set with high yield and securitized may help to diversify corporate credit risk and pursue incremental alpha without compromising the risk profile of the portfolio. We believe these markets are more relevant for an intermediate portfolio than a long-duration portfolio because their duration and curve profiles closely resemble those of intermediate credit.