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LDI Alert

Time to buy credit or Treasuries? Ideas on calibrating the trade-off

Bill Cole, CFA, CAIA, Fixed Income Investment Director
Connor Fitzgerald, CFA, Fixed Income Portfolio Manager
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The views expressed are those of the author 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. 

After hitting derisking triggers in 2021, many plans are looking ahead to the next trigger and asking whether it will make sense to add to their investment-grade credit allocations, given how expensive the market currently is relative to history. And if they decide to wait for a better entry point, what other derisking options do they have in the meantime?

We think conditions in the investment-grade credit market present a bit of a conundrum. On the one hand, fundamentals appear sound and on an upward trajectory. Additionally, technical support is robust, with continued demand from the pension and insurance communities, as well as from individual investors looking for high-quality income. All of this suggests that credit spreads could remain tight for the foreseeable future, in which case plans opting to sit in Treasuries would forgo the credit spread and get “out carried” by their benchmark and liability. (We refer to this forgone spread as the “cost” of owning Treasuries in lieu of corporate bonds.)

On the other hand, with credit spreads so tight, there is not a lot of room for error if they widen, in which case the negative price return could offset the incremental income one can earn by owning corporate credit over Treasuries.

How can plan sponsors weigh this trade-off?

One metric we use to calibrate the attractiveness of investment-grade credit is a spread breakeven. The calculation is simple: The option-adjusted spread of a credit index is divided by the duration of the index. The result tells us how much credit spreads need to widen (in basis points) to offset the incremental income an investor earns by owning corporate bonds over Treasuries.

Figure 1 shows the spread breakeven for the Bloomberg US Investment Grade Long Credit Index and the Bloomberg US Investment Grade Intermediate Credit Index — both are at or near 20-year lows. Long credit spreads need to widen by only 8 bps and intermediate credit spreads by only 14 bps to forgo the incremental spread of owning corporate credit over Treasuries.

This measure suggests that valuations for both long credit and intermediate credit are extremely expensive relative to history. To put this in context, over the last 20 years, there were 77 instances when the long credit index widened by 8 bps in a single day and 38 instances when the intermediate credit index widened by 14 bps in a single day.

Figure 1
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Another way to view this relationship is in terms of historical levels of credit spreads relative to their subsequent three-year excess returns. Figure 2 shows a direct connection between the two. Given today’s spread levels, we think this suggests a very high probability that these asset classes could experience negative excess returns over the coming three years.

Figure 2
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This leads us to believe that it is a very expensive time to buy investment-grade credit and that, absent a big move wider in credit spreads, plan sponsors might want to consider waiting for a better entry point to put their next derisking dollar to work in the credit markets. Importantly, we are not suggesting that plans should sell investment-grade credit that they already own as part of a liability-hedging allocation, as this could result in outsized transaction costs.

What are the alternatives to buying credit today?

For plan sponsors who are reluctant to buy credit at these levels, we think there are a few ways to help prepare for the next derisking trigger.

  1. Consider more flexible investment approaches that target an appropriate amount of interest-rate duration but give the manager flexibility to allocate between Treasury and credit sectors based on the relative attractiveness of different sectors.
  2. Get the infrastructure in place to buy the appropriate amount of interest-rate duration when a derisking trigger is reached. As we saw in 2021, funded ratios can move quickly. Having the pieces in place to react can avoid slippage of funded status in a volatile market. For plan sponsors who elect to buy Treasuries now and investment-grade credit later, it may help to determine the entry point in advance. We think that targeting an option-adjusted spread of 20 bps – 30 bps wider than current levels could be a reasonable target.
  3. Consider alternatives to investment-grade credit. While the Treasury/credit allocation is typically the lever available to most plan sponsors, we have fielded several inquiries on how to diversify the liability-hedging allocation outside of these markets. We think that certain segments of the securitized market can be used as alternatives to investment-grade credit. Allocations to investment-grade private placements could potentially also play a role, for sponsors willing to trade liquidity for incremental yield.

For more ideas, please see our recent paper, “The evolution of derisking: Assessing new and time-tested liability-hedging ideas.” As we approach the end of the year, our 2022 ROA guide may also be a resource in your planning.

Please refer to this important disclosure for more information.


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