Executive Summary
In recent years, many US plan sponsors have adopted liability-driven investing (LDI) in response to changes in accounting standards (FASB 87) and funding requirements (Pension Protection Act). Others have embraced LDI after experiencing the devastating effects from leaving their liabilities unhedged over the past 10 years. Whatever the motivation, this change in strategy should significantly mitigate current pension plan volatility that is negatively impacting companies’ balance sheets, income statements and cash flows.
Pension liabilities are typically discounted by a statutory long corporate rate. Therefore, many pension plans now have a strategic vision to increase their allocation to fixed income assets—specifically long-duration corporate bonds—in an effort to match assets and liabilities. The move to long-duration corporate bonds mitigates the vast majority of liability risk.
Shifting to long-duration corporate bonds is a great first step to reducing asset-liability risk, yet it does not eliminate the risk completely. Residual risk exists because corporate bonds have credit risk, and pension liability values derived from the same corporate bonds are not subject to credit risk.
When a corporate bond is downgraded out of a specified index, the liability discount rate assumes that this bond never existed—it is excluded from the discount rate calculation. Meanwhile, the matched assets experience the full underperformance of the downgraded bond through capital losses. This mismatch makes it impossible for a pension plan to create an asset portfolio that is perfectly aligned with its liabilities. The resulting discrepancy creates a credit downgrade headwind for liability-driven investors.
While it may seem counterintuitive, investing the assets precisely in the liability index (the bonds of the exact duration and capitalization weights of the bonds used to construct the liability discount rate) has not historically been the most risk-reducing strategy. In fact, it would have led to a 14% decline in the funded ratio over the last two decades. Instead, investors should consider the following four approaches to improve their asset-liability tracking:
• Invest in credit-screened bond portfolios,
• Expand the credit universe beyond the liability index,
• Adopt issuer-capped indices, and
• Tolerate downgraded issues.
On an individual basis, each option can help pension plans achieve their ultimate goal: eliminating unrewarded risks in favor of risks that are expected to improve the pension plan’s funded status. Taken together, a pension plan employing these four strategies could have overcome the 14% decline in funded ratios from the credit downgrade headwind experienced over the past 20 years.
The credit downgrade headwind
US plan sponsors are all too aware of their funded ratio volatility. Over the past decade, pension plans have experienced at least two “perfect storm” events in which equities plummeted while pension liability values rose (Hunt 2009). Liability-driven investors aim to weather the funding volatility storms by more closely matching plans assets with plan liabilities.
The liability index, however, poses a dilemma—holding bonds at the index weight and duration may give investors a false sense of precision. For accounting and funding liability valuation, the discount rate is derived from corporate bonds. These bonds expose investors to credit risk through downgrades and defaults. Yet, for the liability index, no such credit risk exists; when a bond is downgraded, it simply drops out of the liability index. The matching asset underperforms the liability and, therefore, exposes the investor to the credit downgrade headwind.
Exhibit 1 charts the funded ratio for a pension plan invested completely in corporate bonds that exactly matched their pension liabilities. While this hypothetical pension plan’s performance is significantly better at matching plan liabilities than a typical US pension plan, the graph clearly illustrates the credit downgrade headwind. In all but two periods, the asset performance is very similar to the liability performance, and the funding ratio remains stable. However, even corporate bonds that perfectly match the liability index fail to keep pace with the liability value during times of market stress, as shown in the shaded regions of the graph. The funded ratio of this fully immunized portfolio would have dropped 14% over the past 20 years as a result of credit downgrades alone.
Downgraded bonds cause the funded ratio to fall. These bonds experience price deterioration in the time leading up to their downgrade and are eventually sold, having underperformed peer bonds. At the same time, after a bond is downgraded, the liability calculation assumes the bonds never existed, as the downgraded bond is excluded from the revised liability index. The liability value seems to take on a life of its own, often rising when bonds are downgraded, causing the funded ratio to fall.
From a forward-looking perspective, the risk of the credit downgrade headwind is very real. Downgraded bonds typically deteriorate in the months preceding their credit event, meaning that the credit spreads widen relative to peers. After a bond is downgraded, the index has a lower average credit spread, implying higher liability values.
Exhibit 2 illustrates the potential impact of a credit downgrade. General Electric’s bonds, highlighted in the chart, represent more than 20% of the Barclays Capital US Long Credit AA Index. Because the bonds’ option-adjusted spreads are on the upper cusp of the index, a hypothetical GE downgrade would cause the average index spread to fall by nearly 20 basis points. A 20 bp decline in the discount rate translates to a 2.4% increase in the liability value for a typical pension plan with 12 years in duration (change in yield × duration = 0.2% × 12 = 2.4%). A pension plan holding the matching bonds in its asset portfolio would not experience an offsetting increase in its investments if GE were downgraded. The assets intended to match the liability, therefore, would have underperformed, exposing the funded ratio to the credit downgrade headwind.
Four ways to overcome the headwind
Liability-driven investors may benefit greatly from the adoption of four investment solutions to mitigate credit downgrade headwinds.
1. Invest in credit-screened portfolios
Actively managed bond portfolios can help avoid deteriorating credits well in advance of downgrades and mitigate the credit downgrade headwind (see “A case study in credit screening” on page 6). To sidestep the headwind, managers must eliminate risky credits from their portfolio months before the downgrade. Strategies that successfully avoid downgrades well in advance are rewarded, essentially winning by not losing.
While this insight may seem obvious, performance analysis suggests it is often underestimated. Exhibit 3 highlights how downgraded bonds perform relative to their peers in the months preceding the downgrade. For example, A-rated bonds underperformed their peers by 4.9% in the month of downgrade and the 11 preceding months; the vast majority of this underperformance (over 3.4%) occurred in the month of downgrade and the two months preceding downgrade.
Successfully screening bonds prior to downgrade provides the most direct opportunity for overcoming the credit down-grade headwind. Active bond managers with demonstrated skill in avoiding downgrades can help liability-driven investors better align asset performance with liability performance.
2. Expand the credit universe
In theory, a matching asset portfolio should include only the bonds used to construct the liability discount rate. In reality, this asset portfolio is often not sufficiently diversified and can be exposed to significant headwind from single issuers.
The investable corporate bond universe is fairly concentrated at maturities of 10 years or greater and exposes investors to unnecessary individual company risk. For example, at year-end 2010, an index of long corporate 6A bonds (those rated A, AA or AAA) held only 160 issuers.6 Although the PPA funding valuation rules specify a 6A index, LDI strategies benefit from expanding the fixed income benchmark. The full, long, investment-grade corporate bond universe has more than twice the number of issuers (350 issuers and 75% more market capitalization than the long 6A corporate bond universe). Additionally, the sector diversification is better in the full, long, investment-grade corporate bond universe. Financials composed 30% of the long 6A index compared with 22% of the long investment-grade index; industrials make up a much greater share of the BBB rated bonds. The investment-grade index improves diversification and decreases concentration risk in issuers and industries.
Widening the benchmark to the full, long, investment-grade universe can also improve a pension plan’s surplus risk/return profile:
• Historical monthly returns of a full, long, investment-grade corporate bond index closely match the pension liability (99% correlation with the long corporate 6A index).
• The full, long, investment-grade corporate bond index has historically outperformed the long corporate 6A index over long time horizons.8 Exhibit 6 shows the improved returns, which are primarily attributable to the fact that the full index has less concentration risk and lower average quality than the narrower long 6A index. The introduction of BBBs produces negative returns during the headwind periods, but rallies stronger than the 6A index during the recoveries. Over long periods of time, the additional volatility has proved beneficial.
Plan sponsors who prefer to keep the weighted-average quality or yield of the bond portfolio matched to the liability index may combine the full investment-grade bond index with a portfolio of Treasury bonds. These Treasury bonds have the added benefit of outperforming the liability during times of strong headwind.
In addition to credit screening, broadening credit exposure beyond the bonds used to construct the discount rate is a useful approach to mitigating the headwind.
3. Adopt capped indices
Even though the liability indices weight the investable universe by market value, investors can cap exposures to large issuers to further reduce the effect of a credit downgrade headwind.
Large issuers typically compose a significant percentage of market-weighted indices, exposing pension plans to unnecessary idiosyncratic risk. Just as issuer-capped indices are a common risk-mitigating technique for high-yield and emerging market investing, they can also be a helpful tool for liability-driven investors.
For example, despite its diversified issuer base, a full investment-grade long corporate index held seven issuers that each consisted of more than 1% of the index at year-end 2010, compared with a long corporate 6A index with 24 issuers that each consisted of more than 1% at year-end 2010, for a total of almost 40% of the index market capitalization. By capping issuer weights, liability-driven investors can limit the impact of downgraded bonds.
Exhibit 7 illustrates how, across most time periods, capped index returns have been nearly identical to uncapped index returns. In 2002 and 2003, when the credit downgrade headwind was very strong, the 1% capped index significantly outperformed the uncapped version of the index.10 The capped index would have gone a long way in mitigating the credit downgrade risk during this period when a few large issues significantly impacted bond index returns. During 2008–2009, the capped index experienced some return volatility, compared with the uncapped index, but still modestly outperformed over the period.
Bond returns are asymmetric. While the upside is limited, the possibility exists for full capital loss during extreme events. Capping issuer weights helps investors reduce their exposure to bond downgrades and defaults, which is a useful approach to mitigate the credit downgrade headwind.
4. Tolerate downgraded issues
Credit screening is the first line of defense against the credit downgrade headwind. However, even the most meticulous screening should be supported by a back-up plan.
For downgraded bonds that were not screened, an active manager should be given discretion to hold downgraded issues for a period of time subsequent to the downgrade. Because the universe of investment-grade managers dwarfs that of junk bond managers, a forced sale of a fallen angel can cause significant price pressure on the bond.
Holding fallen angels after a downgrade can provide meaningful long-term outperformance. A recent study suggests that benchmark rules constrain an investor’s ability to capture the excess returns of credit bonds over Treasury bonds (Ng and Phelps 2010).
The study focused on the credit spread premium, the annual difference between the credit spread and the default costs. From 1990 to 2009, a downgrade-tolerant benchmark—which permits the continued holding of fallen angels—captured 32 bp more of this credit spread premium than the typical investment-grade index, an improvement of 79%. This outperformance was primarily derived from loosening the benchmark constraints and avoiding a forced sale. Giving portfolio managers the flexibility to use their discretion in managing around the investment-grade mandate can add returns that further offset the credit downgrade headwind.
A complete defense against downgrades
Liability-driven investing enables plan sponsors to protect funded status by reducing surplus volatility. However, corporate discount rates for pension liabilities introduce asset-liability risk, even for perfectly immunized index bond portfolios. To further refine their asset portfolio, investors should consider four techniques that can improve their liability hedge:
• Invest in credit-screened portfolios,
• Expand exposure to the full investment-grade credit universe,
• Cap exposures to large issuers, and
• Tolerate downgraded issues.
Each option can independently improve a plan’s funded status over time, compared with the liability index bond portfolio (Exhibit 8).11 Taken together, they present a strong defense against the potential impact of credit downgrades.
Due to the mechanics of the liability discount rate index, the headwind periods are unhedgeable and unavoidable events. Yet, pension plans can prepare for them by reducing exposure to future downgrades and adding small incremental returns. A pension plan employing all four suggested techniques could have fully overcome the 14% decline in funded ratios from the credit downgrade headwind experienced over the past 20 years.
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