Helping DB plans assess the environment: Credit outlook and rebalancing insights

Market volatility has corporate DB plans grappling with questions related to rebalancing, rerisking, and liquidity. In this publication, members of our LDI team offer their market outlook, an update on funded ratios, and insights on rebalancing and liability hedging.

Views expressed are those of the authors and are subject to change. 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.

Market volatility has corporate DB plans grappling with questions related to rebalancing, rerisking, and liquidity. In this April 15 webcast transcript, Portfolio Manager Scott St. John shares his outlook — including observations on markets, liquidity, and new issue supply — and LDI Team Co-Chairs Amy Trainor and Bill Cole offer an update on funded ratios and insights on rebalancing and liability hedging.

Scott, can you discuss your general views on the economy and markets?​

Scott St. John: With the economy, there’s a huge range of outcomes based on the length and severity of the coronavirus impact. It’s very difficult to predict the length of this impact. I think that we’re starting to see the coronavirus data flatten out here, but it’s still uncertain when we’re going to see people going back to work. We must also remember that changes in behavior could last much longer after people go back to work. Our expectations of unemployment are that we’re going to see low double-digits in the second quarter of 2020, and it could get even worse. This is impacting all levels and all economic backgrounds, as we’ve seen everything from restaurants to doctors’ offices closing down. Real GDP growth could be down anywhere from 10% – 30% for the second quarter, and the full year could be down 5% – 10% or even lower, depending on how long people are working from home and the behavioral impacts that we see.

With this dramatic decline in economic growth and expectations, and unemployment, we’re expecting inflation to remain low. We’re seeing 10-year breakeven inflations now around 1.2%, so not a lot of pressure on the Federal Reserve (Fed) to have to raise rates to fight inflation in the near term. And the fed fund futures suggest we’re going to be on zero basically for the fed funds rate for the rest of this year. We saw significant dislocation in the month of March, and what that caused was the Fed to have to step in, announce various bond-buying programs, and this did take away some of the extreme tail risk that the market was quickly pricing in. Ever since March 23, we’ve seen a significant rebound in risk assets. We saw the stabilization of spread markets. Long credit spreads that started out at 140 basis points at the beginning of the year, moved out to close to 360 basis points really quickly during the month of March, and have since recovered back to around 240 basis points. At this point, I do feel the market’s closer to fair value, but I think there are still some opportunities there.

In light of this, how are you positioning portfolios? Is it time to buy long credit?

Scott St. John: During the month of March, we added credit risk to the portfolios. We had come into the beginning of March with a fairly defensive position, with our long credit mandates mostly short around one year of credit spread duration. During the month of March, we added enough corporates to basically get to 0.2 years short of credit spread duration within the long corporate credit mandates that we manage. So, March did provide a lot of opportunity in the markets, as we saw significant repricing.

We are in an environment, though, where I think some of the more challenged sectors/segments will continue to face potential widening pressure if not downgrade risk, while there are certain other areas of the market where there are opportunities. And when you look at the overall spread of…

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