Why should pension plans consider allocating to intermediate credit?
Beyond the points above, corporate pensions with LDI strategies may find intermediate credit appealing for the following structural reasons:
- Natural shift of liability duration toward the belly of the curve: The extraordinary measures taken by the Fed to battle inflation caused discount rates to rise by over 200 bps over the course of 2022 (as per the Bloomberg Long Corporate Aa Index). Many plans experienced a natural reduction in cash-flow liability duration as yields rose, resulting in a structural increase in shorter-term liability cash flows or front-end partials. Plans might have undergone structural liability shifts since first implementing their LDI programs. We know that frozen and closed plans have matured, which reduces duration, but at the same time, plan sponsors have been active in lump-sum payouts and pension risk transfers, which can have varying impacts on liability structure. To ensure liability-hedging strategies are still aligned with the risk profile of the liabilities, we recommend that plans refresh their data and re-underwrite their hedging portfolio allocation.
- Improved funded status: At the same time, the improvement in funded ratios since year-end 2020 has spurred further derisking. With more capital allocated to the hedging bucket, plans may not need to be as capital efficient within this allocation, opening up a role for intermediate credit to gain spread exposure across the maturity curve. The competitive all-in yields within intermediate credit offer an attractive entry point for plans looking to lock in improvements in funded status without a meaningful give-up in income and return.
- Credit hedge ratio: Some plans may be overallocated to spread duration in their liability-hedging portfolio after taking into account the implicit spread duration from equities (or, alternatively, the positive correlation between equities and excess credit returns). Derisking into intermediate credit, with its lower spread duration, may help mitigate this “overhedging” while still allowing for attractive income, provided that the plan can use other tools in the hedging portfolio to manage its target interest-rate hedge ratio.
We would encourage well-funded plans to reevaluate their current asset allocations against their liabilities and target interest rate and credit hedge ratios to determine whether a change is warranted and aligns with the plan’s overall objectives.
While we believe investment-grade intermediate corporates offer potential for sustainable value and downside protection in today’s environment, the heavier composition of the banking sector within this segment of the market could be of concern. Spreads may be more vulnerable as a result, but we think the ample cushion in breakevens, irrespective of the catalyst for a rise in yields, should be able to absorb a portion of losses caused by adverse moves.
Overall, we think intermediate corporates exhibit a compelling risk/reward profile and relative attractiveness within fixed income. In an uncertain macro environment such as the one we find ourselves in today, active management may play a critical role in navigating credit market volatility. However, the success of a portfolio comes down to manager skill in underwriting risk.