The rise in corporate bond yields over the past few years caused several chain reactions affecting corporate defined benefit plans:
- The average plans’ duration has decreased.
- The average funded status has vastly improved (helped by strong equity returns), racing through glidepath triggers and requiring increased fixed income allocations.
- Higher fixed income allocations are now driving two asset allocation decisions within fixed income:
- The desire for alternatives to corporate credit - the top 10 issuers in the Bloomberg US Long Corporate and Long Credit Bond Indices represent ~15% of each Index.
- A need to focus on hedging intermediate duration liabilities to mitigate curve risk.
We believe plan sponsors can address these needs with an allocation to an Intermediate Aggregate strategy - the plan receives exposure to a broader opportunity set with diversification from the high-quality securitized space.
Is it time to consider a shorter path?
- Plans often calculate the present value of their liabilities using discount rates based on high quality, mostly AA-rated corporate bonds. To reduce funded status volatility, many plans invest substantial portions of plan assets in long corporate bonds.
- However, corporate pensions’ fixed income duration needs have been trending down. With most plans soft or hard frozen, liability durations will continue to decrease as plans age.
- Recent higher funded statuses and increased allocations to fixed income have also resulted in reduced duration requirements to maintain target hedge ratios, which now makes an intermediate allocation more attractive.
- An intermediate allocation can also help reduce curve risk without getting as precise as duration/cash flow matching or pure immunization.
Adding an Intermediate Duration Index can help meet hedge ratios, while also providing broader curve exposure and improving the hedge with liabilities.
What path to take in the intermediate space?
- For most plans, the return-seeking component continues to be higher beta versus the liability return, usually coming in the form of equities or, in fixed income, lower-rated and/or illiquid credit.
- In our view, higher beta fixed income has disadvantages during periods of volatility as this allocation can reduce liquidity and cause higher negative skew versus liabilities.
- A pure Credit Index does not help mitigate these risks, and many plans already have large allocations to corporate credit. However, the securitized market offers a high quality, liquid, diversified, and lower volatility alternative to corporate credit in the intermediate part of the curve.
An alternative to Intermediate Credit is allocating to the Bloomberg US Intermediate Aggregate Bond Index where securitized comprises ~34% of the underlying Index.
How to navigate the securitized market along an LDI journey?
We define high quality securitized primarily as Agency MBS, AAA CMBS, and AAA Consumer ABS.
- Agency MBS is a large market (~9.3bn in market value^), offers good liquidity (especially in the TBA market), has an implicit/explicit government guarantee, and delivers diversification versus corporate credit.
- AAA CMBS and AAA Consumer ABS offer very good liquidity and structural protections that can reduce both correlation and downside versus corporate credit.
- Plan sponsors may consider limiting exposure to Non-Agency RMBS and Agency CMOs, due to weaker liquidity, as well as avoiding CLOs, Aircraft ABS, and other non-AAA securitized sectors, due to little diversification benefit versus corporate credit.
Our analysis of high quality securitized has shown the following:
- Securitized tends to widen with corporate credit during liquidity crises, but not when widening is credit specific (Exhibit 1).
- Securitized shows a low correlation of excess returns to other spread sectors and very low correlation to equities (Exhibit 2).
- Securitized has outperformed U.S. Treasuries and the risk-adjusted returns are attractive compared to high quality corporate credit (Exhibit 3).
We believe by incorporating high quality securitized assets into an LDI asset allocation strategy a plan can achieve diversification, increase liquidity, and reduce funded status volatility (particularly on the downside).
Where is the bump in the road?
One of the main reasons LDI investors have shied away from securitized in an LDI framework is the negative convexity of Agency MBS, which results in fluctuating durations.
- Agency MBS’ price/rate relationship is negatively convex, due to the likelihood the homeowner will refinance into a lower-rate mortgage when yields fall, and conversely, the homeowner’s tendency to remain in the mortgage when yields rise. As a result of prepayments, the expected maturity (duration) of the security shortens, as principal is returned sooner, and the investor will be faced with reinvesting at lower rates. When rates increase and prepayments slow, the duration extends.
These risks can be managed through active portfolio management that utilizes sector rotation, security selection, portfolio hedges, and duration management.
- For example, we evaluate changing Agency MBS durations in determining relative value and hedging. We keep the total portfolio duration neutral to the benchmark, and we utilize ten key-rates (1yr, 2yr, 3yr, 5yr, 7yr, 10yr, 15yr, 20yr, 25yr, and 30yr) to hedge our Agency MBS exposure versus the market practice of only using the 10yr key-rate.
Does a shorter, different path fit your plans’ objectives?
- We believe active investors in the securitized market, specifically in Agency MBS, have significant opportunities to generate alpha from sector rotation, security selection, and duration management.
- Historically, the risk-adjusted returns of the Securitized and Intermediate Aggregate Indices have offered a competitive alternative to corporate credit indices with a lower volatility profile.
- By allocating to an Intermediate Aggregate strategy, a plan gets additional diversification (via its securitized exposure) versus corporate credit and a low correlation to equities, especially during times of market stress.
- At Jennison, we have more than 40 years of experience partnering with our pension clients in crafting custom LDI solutions. We can help clients navigate the unique risks and opportunities of the market to determine if an Intermediate Aggregate strategy can help meet your plans’ objectives.
Jennison Associates
Jennison's investing approach is rooted in our fundamental research and security selection; all of our portfolios are built from the bottom-up, security by security.
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End Notes
Sources:
Jennison Associates LLC Moody’s Investor Services, Inc. eVestment
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There is no guarantee our objectives will be met. All investments contain risk, including possible loss of principal. The strategy may vary significantly from the benchmark in several ways including, but not limited to, sector and issuer weightings, portfolio characteristics, and security types. Diversification does not protect an investor from market risk and does not ensure a profit or guarantee against a loss.
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Market Definitions:
Beta – a measure of the volatility of a security or portfolio compared to the market as a whole.
Duration - a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. Excess Return - is the additional return generated by the portfolio or composite relative to its benchmark.
Maturity – the date on which the life of a transaction or financial instrument ends, after which it must either be renewed or it will cease to exist. The term is most commonly used in relation to bonds but is also used for deposits, currencies, interest rate and commodity swaps, options, loans, and other transactions.
Option Adjusted Spread (OAS) - the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.
Sharpe Ratio – a measure of an investment’s risk-adjusted performance, calculated by comparing its return to that of a risk-free asset.
Standard Deviation – a statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance. Yield – a general term that relates to the return on the capital you invest in a bond.
Yield to Worst (YTW) – a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting.
