Archived insights remain available on the site. Please consider the publish date while reading these older insights.
publish

LDI Alert —
In a volatile time, defense may be on sale

As corporate pensions consider enhancements to their return-seeking portfolios, LDI Team members Amy Trainor and Jake Brown explain why we may be at an attractive entry point for defensive equity and “bridge” strategies.

 

The views expressed are those of the authors 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. 

Despite a strong equity market since the end of March , plan sponsors have seen only modest improvement in funded status as rates remain at historic lows. This may leave plan sponsors wondering, “What happens to my funded status if equities stumble?” It’s a reasonable question given the potential sources of volatility on the horizon, from the US election to developments in the pandemic. We think it ties directly to another question that we’ve been discussing with plan sponsors: Is now a good time to broaden the return-seeking opportunity set in an LDI portfolio?

First, some context: The collapse of the US economy in the first quarter was unique in that it was brought about not by the usual suspects, such as tightening monetary conditions, but by the exogenous shock of a pandemic and the required rapid shutdown of much of the economy. The corresponding collapse of financial markets was unique as well. In most economic downturns, higher-beta sectors, like technology, decline the most. But during the COVID-19 sell-off and the subsequent rebound, the technology sector was one of the top performers, as many people moved to a work-from-home environment and became more reliant on technology, e-commerce, and social media. At the same time, lower-beta sectors, such as infrastructure and REITS, both of which may offer defensive qualities given their stable cash flows and yields, provided less protection than expected in the sell-off and, for the most part, lagged the market in the rebound. Stocks in these sectors generally underperformed on recollections of 2008, when real estate was at the epicenter of the crisis, and concerns around potential rental and utility-rate forbearance, which we believe will prove to be exaggerated.

As a result, we think some defensive areas of the equity market are on sale at a time when plan sponsors may want to consider adding them to return-seeking portfolios. In our framework for return-seeking portfolio construction (see our recent white paper), we incorporate both defensive equity strategies, which seek balanced upside and downside participation (e.g., 95% upside capture/85% downside capture), and “bridge” strategies, which aim to deliver meaningful downside mitigation when funded ratios are under duress — particularly in “perfect storm” environments where the twin headwinds of falling equities and falling rates can devastate funded status. Examples include liquid infrastructure, real estate, and “growth” fixed income strategies (the latter generally focused on dedicated or rotational spread sector exposure).

As noted, the current environment may present an attractive entry point for some of these areas of the equity market. For example, we think segments of the liquid infrastructure universe, such as utilities, are attractively valued. And real estate cap rates (net operating income divided by real estate value) may offer compelling net rental yields relative to Treasuries (Figure 1), given performance during the drawdown and recovery and the compression in yields facilitated by central bank purchases.

FIGURE 1

REIT net rent yields
Beyond valuations, we see a strong fundamental case for these assets:
  • Liquid infrastructure: We include industries such as utilities, transport, communications, and renewables in this category. We believe the structural opportunities around renewables and grid modernization offer a longer-term growth runway for many infrastructure companies as global economies seek to reduce reliance on carbon-based energy.
  • Real estate: Due to contractual lease obligations, REIT earnings are generally less volatile than those of broad equities, potentially providing some downside mitigation in a drawdown scenario. In addition, balance sheets have improved substantially since the global financial crisis. We think these attributes are underappreciated by the market. And the structural changes to real estate resulting from long-term trends, some of which have accelerated under COVID-induced quarantines, could lead to substantial dispersion between winners and losers, creating opportunities for active managers. For example, cell towers/data centers are benefiting from increasing data usage while brick-and-mortar retail is shrinking.
As we enter the fourth quarter, equities may struggle to maintain the pace they have set since the end of the first quarter. Plan sponsors might consider taking advantage of the valuation opportunities created by recent equity market dynamics to add exposure to attractively priced defensive sectors that retain solid fundamentals.

Please refer to this important disclosure for more information.

Recommended for you

Fighting downgrade drag to reduce pension liability lag
Even robustly constructed liability benchmarks can struggle to keep pace with the liabilities they are meant to represent, and credit-rating downgrades of issuers in the benchmark are a primary culprit. In this paper, members of our LDI Team define the problem and offer ideas to help plan sponsors and LDI managers work together to fight back.
November 2020
Fighting downgrade drag to reduce pension liability lag
,
Bill Cole
 CFA, CAIA
Louis Liu
 PhD, CFA, ASA, MAAA
Expanding the liability-hedging tool kit: A securitized solution?
Concerned about concentration risk, liquidity issues, and other factors that can affect long corporate bond allocations, derisking pension plans are seeking opportunities to diversify their liability-hedging allocations. In this paper, members of our LDI Team share their research on securitized assets as a potential alternative.
September 2020
Expanding the liability-hedging tool kit: A securitized solution?
,
Setting ROAs for 2021: A guide for US public and corporate plans
How are pension plans adjusting their ROA assumptions? How do those assumptions line up with our long-term capital market assumptions? Find out in this annual update.
September 2020
Setting ROAs for 2021: A guide for US public and corporate plans
,
Constructing next-generation return-seeking portfolios
As corporate DB plan sponsors finalize their liability-hedging allocations, a growing number are considering how to structure their return-seeking allocations. Members of our LDI Team propose a portfolio construction framework that emphasizes funded-ratio growth via a more stable path of returns.
March 2020
Constructing next-generation return-seeking portfolios
,
STRIPS and synthetic overlays: A plan sponsor’s guide to the duration-extension decision
Many corporate defined benefit plans are contemplating strategies to increase the hedge ratios of their portfolios. There are multiple options to consider, in both the cash bond and derivatives markets. Here we looks at the pros and cons of each and the case for active management in implementation.
May 2019
STRIPS and synthetic overlays: A plan sponsor’s guide to the duration-extension decision
,
Allan Levin
 CFA, FRM, FSA
Bill Cole
 CFA, CAIA
Cash-balance liabilities: A new investment framework
A cash-balance plan is very different from a traditional pension plan, and the differences can have a major impact on the interest-rate sensitivity of the plan’s liability. In this paper, we consider the implications of a cash-balance plan’s design and propose an investment framework focused on capital preservation, consistent income, and liquidity.
April 2019
Cash-balance liabilities: A new investment framework
,
Louis Liu
 PhD, CFA, ASA, MAAA