Pensions entered the Covid-19 pandemic significantly exposed to corporate credit risk, relying on a traditional investment strategy that may be heading for failure, according to JPMorgan Chase & Co.’s asset management group.
They’ve been hedging the volatility of their pension liabilities by taking on “a very concentrated exposure to corporate credit,” Jared Gross, the head of institutional portfolio strategy at J.P. Morgan Asset Management, said in a phone interview. Largely holding corporate bonds at risk of being downgraded to junk in the downturn, plus Treasuries with historically low yields, won’t work well for ensuring workers receive the pension benefits they’re owed, according to Gross.
“If a classic fixed-income portfolio is yielding 2 percent, that’s not going to get the job done,” he said. “You have a concentrated exposure in investment-grade corporate credit, which is both relatively low-yielding today and likely to be exposed to higher than normal levels of credit volatility.”
One of the most sensible ideas for pensions with liability-driven investments consisting of corporate debt and Treasuries is to move some portion into securitized mortgages — a high-quality, long-duration asset class they’ve been avoiding for the past ten to 15 years, according to Gross. He said that would create a “safety valve” for LDI portfolios designed to help pensions meet their long-term obligations to workers.
“It really kind of neatly fits in the middle in a very useful way,” Gross said. “It is higher quality than corporates and you probably give up a little bit of yield — but not much,” he explained. And “it has significantly higher yield than Treasuries.”
Gross estimates that pensions typically hold about 75 percent of their LDI portfolios in investment-grade corporate bonds and 25 percent in Treasuries. Having a third place to put capital would provide more flexibility in changing markets, he said, particularly as the pandemic weighs on company earnings and after the Federal Reserve’s emergency intervention in credit markets drove down yields.
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“Managing an underfunded pension plan relative to its liabilities is like walking up a down escalator,” said Gross. “At a high level, institutional investors do need to reassess the asset-allocation framework.”
The aggregate funded ratio for U.S. corporate pensions fell 1.3 percentage points in July to about 80 percent, according to Wilshire Associates. That compares with a funding ratio of 88.8 percent a year earlier.
“July marks the first monthly decrease in funded ratio since the market recovery that started in April,” Ned McGuire, a Wilshire managing director and member of the firm’s investment management and research group, said in a statement last month. The drop resulted from rising liability values tied to declining Treasury yields and tighter corporate bond spreads, he said. While the funding ratio improved in August, increasing to 84.7 percent, Wilshire said Wednesday that it remains down in 2020 due to rising liabilities.
Pensions typically pay out between 6 percent and 10 percent of their assets each year, according to Gross, who has long worked with this group of investors. He is filling a newly created role at JPMorgan in New York.
J.P. Morgan Asset Management announced in July that it hired Gross from Pacific Investment Management Co., where he had worked for more than a decade, most recently as the head of institutional business development. Before Pimco, Gross co-headed pension strategy at Lehman Brothers Holdings and worked on the pension solutions team at Goldman Sachs Group. Beyond Wall Street, he has advised investment policy at the Pension Benefit Guaranty Corp. and served as a senior advisor for domestic finance at the U.S. Department of the Treasury.
“I wound up at Pimco during the financial crisis, which was to a large extent, the starting gun for broad-based adoption of LDI investing,” said Gross. “You could buy portfolios at seven or eight percent returns.”
While a “a great entry point for a lot of LDI investors” at the time, Gross believes the strategy now has to evolve, and that securitized mortgages in commercial and residential real estate should become part of portfolios. “Most of these are AAA-rated,” he said of the components of securitized mortgages he sees fitting well into their holdings.
Beyond LDI portfolios, institutional investors should also consider owning income-producing hard assets, such as real estate, transportation, and infrastructure, according to Gross. He also suggested that pensions — in a world of low rates and stocks trading around record highs — hunt for more yield in private markets.
“There are no free lunches,” Gross said. “We have to take risk somewhere.”