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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.
Market composition: How does the intermediate credit market compare to the long credit market?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.
- Consider using corporate rather than credit indices. This may reduce structural exposure to the government-related sector, which can be an incremental source of tracking error relative to a plan’s discount rate — given that the discount rate is derived from the yield of corporate issuers.
- Consider benchmark-relative industry limits across intermediate and long-duration portfolios, as opposed to absolute limits. Absolute sector limits (e.g., limiting financial sector exposure to 35%) can be more restrictive in an intermediate portfolio given the concentrated nature of the market in certain industries, which can limit a manager’s ability to express active views on the attractiveness of different industries.
Investment guidelines: Should there be flexibility with non-benchmark sectors?
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.
- Consider allowing for the opportunistic use of high-yield and securitized assets in intermediate portfolios, in moderation, as an additional source of alpha potential. A limit of 5% – 10% may be a reasonable place to start.
Portfolio construction: A discrete allocation or a blended benchmark?
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.
- For plan sponsors who want to maximize alpha potential and can tolerate some deviation from the policy allocation between long and intermediate credit, there may be a benefit to running the mandate against a custom blended benchmark.
- For plan sponsors who prioritize the precision of the liability hedge, maintaining separate allocations may be the better approach.
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.