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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.
MANY CORPORATE PLANS HAVE SEEN FUNDED-RATIO IMPROVEMENTS THIS YEAR thanks to higher discount rates and equity market strength. We’ve spoken with several plans that are now at their next derisking trigger and seeking exposure to intermediate credit to hedge liabilities — either because their plan is closed and its duration is declining every year or because it has a large liability-hedging allocation and no longer needs capital-efficient sources of duration and spread duration to hedge liabilities.
Anticipating that a growing number of plans will follow a similar path, we wanted to highlight some notable differences between the intermediate and long-duration segments of the investment-grade market, as well as call out a few investment considerations that relate to these allocations.
The intermediate segment of the market (1 – 10-year maturities) is significantly larger and more liquid than the long end (10+ year maturities). Figure 1 flags other differences between intermediate and long indices, as well as between corporate and credit indices. For example, the intermediate indices have a much larger allocation to the financial sector than the long indices. And, of course, the credit indices have allocations to the government-related sector, which is comprised of taxable municipals, sovereigns, and supranationals. It is important to point out that many of the supranationals trade with extremely tight spreads to Treasuries (currently inside of 15 basis points) and are very illiquid, which means that transaction costs alone can offset any excess return potential for the sector. Taxable municipals also tend to be very illiquid and difficult to source.
Certain non-benchmark sectors may be more additive to an intermediate credit portfolio than to a long-duration portfolio. For example, since the average maturities of the securitized and high-yield markets are significantly shorter than the average maturity of a long-duration credit benchmark, incorporating them in a long-duration portfolio requires the use of synthetic duration to hedge the interest-rate exposure back to a long-duration benchmark. This can potentially introduce incremental cost and basis risk. Securitized and high-yield assets may be a better fit in an intermediate portfolio, given their similar maturity profiles and potential to provide diversification to corporate credit.
For the foreseeable future, we think many plan sponsors will need to maintain allocations to both long and intermediate credit in order to properly hedge plan liabilities. We are often asked whether it makes sense to maintain separate allocations to the two markets or to use a custom blended benchmark. We see pros and cons to each approach and think it ultimately depends on the plan’s overarching objective.
Managing a single portfolio against a custom blended benchmark allows a plan to use existing custodial arrangements and documentation (for those with separate accounts). As plan liabilities evolve, changing the composition of the portfolio’s credit allocation can be as simple as changing the custom benchmark to reflect the desired blend of intermediate and long bonds. This approach can potentially limit turnover in the portfolio. When bonds “roll out” of the long-duration benchmark, they “roll into” the intermediate benchmark. This can eliminate the risk that a manager has to sell from one portfolio and buy from another.
One consideration with the custom blended benchmark is that it introduces the possibility that a manager will overweight or underweight different segments of the credit market, depending on the quality of the opportunity set. While this may create more opportunities to add alpha, it could also reduce the precision of the liability hedge — something to be aware of if the objective of the allocation is to target a specific amount of capital to hedge front-end and longer-dated liabilities.
Please reach out to us if you would like to learn more about intermediate credit allocations in a derisking plan. Additional LDI research and implementation ideas can be found here.
Please refer to this important disclosure for more information.