Fixed income
Fixed income

Looking beyond traditional LDI instruments as de-risking gathers steam

The time may be here to lock in healthy funding levels

March 23, 2023 | 7 min read
Owais Rana
Head of Investment Solutions, Fixed Income
Matthew Dunleavy
Product Specialist, Fixed Income
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Key takeaways

  • It has taken almost 15 years for many private defined benefit plans to finally see higher average funded ratios. This was mainly driven by a large fall in liability values that are discounted on a high- quality corporate bond yield curve.

  • DB plans have patiently waited for the long-dated interest rate to rise. The time may be here to de-risk by swapping out equity-like exposure in favor of fixed-income assets to lock in the funded status gains with the goal to defease the asset-liability mismatch risk.

  • We believe plan sponsors should consider a new toolkit when it comes to developing a liability-driven investing (LDI) strategy. We favor adding esoteric assets such as private investment grade credit, commercial mortgage loans, and non-agency collateralized mortgage-backed securities to help uplift the overall quality of a LDI strategy.

In 2022, we saw one of the most unprecedented movements in global financial markets in modern history. A combination of global geopolitical problems and supply-demand imbalances of goods and services due to the pandemic left the Federal Reserve (Fed) with no option but to try and slam the inflationary brake by hiking short- term interest rates to stop the economy from overheating. The capital markets across the board went downward, with U.S. S&P 500 returning -19.4% and U.S. Treasurys returning -12.5% over 2022.

As most asset owners were in despair having seen their wealth significantly depleted, there was a silver lining for at least one group of asset owners that had waited for such a scenario—the private defined benefit (DB) plan sponsor. This group of plan sponsors had been eagerly waiting for the long-dated Treasury to finally drop in value. As a result, the average funded ratio as of December 31, 2022 stood at 110%, according to the Milliman Pension Index.

Indeed, it has taken almost 15 years for the private DB plans to finally see higher average funded ratios. This was mainly driven by a large fall in liability values that were discounted on a high-quality corporate bond yield curve. Even the explosive equity bull market era proceeding the Global Financial Crisis failed to drive the industry’s average funded status into positive territory because a commensurate rally in the long-dated Treasury (hence corporate bond) market kept increasing the plans’ liability values.

For those plans that have patiently waited for the long-dated interest rate to rise, the time may be here to de-risk by swapping out equity-like exposure in favor of fixed-income assets to lock in the funded status gains with the goal to defease the asset-liability mismatch risk. For those new to the DB pension industry, one thing to learn from 2022 is that the long-dated interest rate is one of the main drivers of risk in liability values. In our view, this is an uncompensated risk and most of it should be hedged as part of an asset allocation strategy.

Historical funding levels, interest rates, and equity returns

Comparison of S&P returns, 10-year interest rates, and Milliman pension surplus/deficit, July 2000 to July 2022.

As of October 31, 2022. Source: Principal Asset Management, S&P 500, Milliman Pension Surplus/Deficit.

New environment, new toolkit

We recognize that not all pension plans are built the same in terms of their liability structure, sponsor’s risk appetite, their investment/risk management objectives, and their governance structure. It’s critical to understand a plan’s circumstances and develop a custom liability-driven investing strategy that’s based on their specific requirements and objectives.

The first level of investments needed to develop a custom LDI strategy are high-quality public market credit and risk-remote assets, such as Treasury bonds, STRIPS, and interest rate derivatives. These instruments can be structured to mimic the risk exposures of the liability term structure. This toolkit can be further enhanced by taking the “blunt” credit strategies and breaking them down by maturity buckets to enhance the overall fit between assets relative to the plan’s liability stream.

After a plan has allocated a significant amount of its hedging assets to a public market credit portfolio, a second level of investments to consider are additional high-quality esoteric fixed-income assets. These include (but aren’t limited to):

  1. Private Investment Grade Credit
  2. Commercial Mortgage Loans (CMLs)
  3. Non-Agency Collateralized Mortgage-Backed Securities (CMBS)

These fixed-income securities are typically issued across the term structure but may have more appeal around the 10-year maturity mark given the yield and overall size of the issuance there. Therefore, a portfolio of these securities can be augmented effectively into an LDI framework that can typically uplift the overall quality of the LDI strategy without sacrificing its efficacy.

Learn more about the new investment considerations


PRIVATE INVESTMENT GRADE CREDIT

The private investment grade (IG) credit market, also known as private placements, is comprised of unregistered bond offerings to small groups of qualified investors. The private credit market is an extension of the public IG corporate bond market. The market is approximately $750 billion to $1 trillion in size, and issuances are mainly by middle market companies (approximately equivalent to $1-$5 billion market capitalization), some being large multi-nationals, and by both privately owned and publicly traded companies. Typically, up to 50% of the issuers are domiciled outside of the U.S., with about 80% of the market issuance denominated in U.S. dollars. Historically investors in private placements have been insurance companies and large asset managers. More recently private placements have seen increasing interest from pension funds and LDI portfolios.

Private Investment Grade Credit can offer several benefits for LDI strategies, including:

  • Incremental yield potential over public bonds
  • Significant covenant protections
  • Improved recoveries in distress
  • Diversification away from the public bond market
COMMERCIAL MORTGAGE LOANS

Core commercial mortgage loans (CMLs) are private, direct investments in senior debt secured by apartment, industrial, retail, office, and other types of income-producing real estate. Individual investments typically are not rated by public ratings agencies, but investment managers frequently assign credit ratings to individual CMLs based on each investment’s credit metrics relative to historical asset class performance, with investment grade credit ratings of AA through BBB+ common for core CMLs.

Core CMLs can offer LDI investors several primary benefits:

  • Attractive credit risk profiles, with multi-tenant properties providing diverse sources of repayment and high-quality collateral significantly reducing losses sustained after defaults;
  • Appealing relative value, with core CMLs frequently offering spreads 30-70 basis points greater than corporate bonds of comparable credit quality and tenor;
  • Healthy current income returns, considering the relatively large coupon component of core CML total returns
  • Limited correlation of returns with other fixed income asset classes;
  • An ability to tailor terms to help meet specific portfolio needs; and
  • Effective call protection, with yield maintenance requirements standard in the market.
NON-AGENCY COLLATERALIZED MORTGAGE-BACKED SECURITIES

Commercial mortgage-backed securities (CMBS) are bonds secured by first mortgages from commercial real estate properties located across the United States. The sector spans real estate and fixed income as the public market counterpart to investing in private commercial mortgage loans. From a fixed income perspective, CMBS falls within the broader structured product universe as a component of the Bloomberg U.S. Aggregate Index. There are several different types of CMBS with fixed rate conduit CMBS being the most likely fit within a LDI framework given its longer duration, strong pre-payment protections, and diversified credit profile.

CMBS can offer three primary benefits for LDI investors:

  • Yield enhancement is derived from the excess credit spread that CMBS offers relative to corporate bondsof similar duration and rating. This yield pickup can be substantial as CMBS bonds from AAA to single-A currently out-yield corporate bonds rated at least two full ratings notches lower;*
  • Diversification complements yield enhancement as CMBS correlations vs. fixed income alternatives are historically less than 1.0. Very high quality, lower yielding index-based CMBS strategies offer less diversification, while more credit-oriented strategies offer higher yields and lower correlations;*
  • Alternative credit exposure lies in the fact that CMBS are ultimately secured by commercial real estate properties. CMBSprovides efficient and highly diversified access to real estate debt exposure without long investment ramp up periods or high commitment amounts.

*Source: Bloomberg, JP Morgan Research, Principal Real Estate Investors. As of February 2023.

Key characteristics

Key characteristics of new investment considerations

As of December 31, 2022. Source: Principal Asset Management. For illustrative purposes only. Not intended to predict actual results.

Merits of adding these asset classes within the LDI framework include:

  • Improved diversification of the overall portfolio.
  • Higher yield of the overall portfolio reflecting some illiquidity risk and some market dislocation.
  • Private IG has better covenant protection given the terms negotiated bilaterally relative to public IG.
Disclosure

Risk considerations
Investing involves risk, including possible loss of principal. Past Performance does not guarantee future return. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed. Fixed‐-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Potential investors should be aware that Investment grade corporate bonds carry credit risks, default risk, liquidity risks, currency risks, operational risks, legal risks, counterparty risk and valuation risks.

Important information
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This material may contain `forward-looking’ information that is not purely historical in nature and may include, among other things, projections, and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

All figures shown in this document are in U.S. dollars unless otherwise noted. All assets under management figures shown in this document are gross figures, before fees, transaction costs and other expenses and may include leverage, unless otherwise noted. Assets under management may include model-only assets managed by the firm, where the firm has no control as to whether investment recommendations are accepted, or the firm does not have trading authority over the assets.

Index performance information reflects no deduction for fees, expenses, or taxes. Indices are unmanaged and individuals cannot invest directly in an index.

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