The significant widening of global credit spreads since the start of the COVID-19 crisis has created opportunities for patient investors who wait to be appropriately compensated for risk. Specifically, for corporate pension funds it creates the opportunity to invest in long credit to better match their liabilities and improve the yield on their liability-driven investment (LDI) portfolios, with U.S. and European investment grade (IG) spreads still around 1 percentage point above their 19 February levels.
For corporate pension funds, increased exposure to long credit could help :
- Close the spread duration gap: European corporate pension funds are generally underweight spread duration versus their liabilities. In the current market environment, wider spreads offer an opportunity to invest in long credit at better levels. This should help corporate pension funds achieve a closer match between assets and liabilities by tightening the duration gap.
- Lock in liability gains: The recent spread widening has driven down the value of liabilities, as the AA curve corporate pension funds use for discounting is now higher. This has benefited funding positions as LDI portfolios with lower spread duration have not suffered as much.
- Unwind credit default swap (CDS) overlays: Some pension funds have hedged their liability spread duration with CDS overlays (iTraxx, CDX or similar). In the recent phases of market volatility, these hedges have not worked well, as CDS levels increased less dramatically than spreads on physical bonds. This has benefitted pension funds’ as CDS hedges (an asset) have declined less than liabilities. However, these gains would be undone if spreads on bonds came back down and the gap versus CDS narrowed. Therefore, this might be a good time to switch from CDS to physical credit solutions to book the gains and improve liability matching.
- Interest rates could be lower for longer: PIMCO’s Cyclical Outlook in April stated that we may be entering a New Neutral 2.0– a phase in which real interest rates continue moving lower given low growth, low inflation, as well as other secular forces, including technology. With this in mind, the recent credit sell-off could be a good opportunity for euro investors to lock in investment grade (IG) credit yields at around 2% over bund yields.
Need to diversify
Because accounting standards prescribe that pension liabilities be discounted using an AA corporate bond curve, corporate pension fund LDI portfolios should ideally include the most AA-like assets, i.e., long-dated, high-quality euro-denominated credit. The problem is that the long end of the euro credit market is relatively small, making it hard to build a diversified LDI portfolio. Figure 1 shows that only about 5% of the euro corporate bond market has a remaining maturity of more than 20 years. In the U.S., this segment makes up almost 25%.
This has led many European corporate pension funds to match the longer liability duration by using government bonds and swaps. This has helped them match duration – but not spread duration, or the price sensitivity to changes in spread levels (and not interest rates).
At present, this has not been a bad thing because government yields have come down, lifting the price of LDI assets, while yields of corporate bonds rated AA have increased following the widening of corporate spreads – reducing the present value of liabilities (Figure 2).
Rising assets and falling liabilities have been a positive for LDI portfolios, but these benefits could be undone if AA spreads tighten, as a lower yield would reduce the discount rate, increasing the present value of liabilities more than the present value of assets (if the asset pool doesn’t include enough long-term credit to match a similar increase in value). Thus, rather than relying on government debt, pension funds should increase their exposure to corporate credit, especially when trading at attractive levels, in order to avoid a liability mismatch.
Matching spread risk with CDS
Instead of relying on the long and more diversified U.S./global credit market, some pension funds have tried to match their asset-liability spread duration using CDS exposures, including Europe’s iTraxx IG index. This approach has its limitations because CDS levels and spreads on physical bonds can deviate substantially at times. As Figure 3 shows, this happened in the recent sell-off with CDS levels increasing, but not as steeply as physical bond spreads. In this case, it was to the pension funds’ benefit as their liabilities went down in value more than the CDS hedges. But, again, these gains would of course be undone if credit spreads come back down and the cash-CDS difference narrowed. In this scenario, allocating to long credit would lock in the profits.
The theory, in practice:
Let’s now put our thoughts into practice: Figure 4 shows two LDI solutions for a typical European corporate pension liability profile.
- The first invests only in euro assets (government bonds and credit), as well as interest rate swaps to match the liability duration. Its mismatch risk is near 4%.
- The second solution allocates to long global credit, hedging currency and duration back to euros and reduces mismatch risk from near 4% to under 2.5%, and, at the same time, increases portfolio yield by about 0.5 percentage points.
For comparison, we show the outright volatility of the liabilities of around 10%, indicating that the euro-only solution matches almost two-thirds of the liability volatility, while the LDI portfolio with long global credit does significantly better, matching over 75%.
The diversified solution’s mismatch risk of 2%-2.5% may still seem high, but we need to bear in mind that pension liabilities cannot be perfectly matched due to their very long dated nature, and the technicalities of the AA corporate bond yield curve discounting. Even if longer-dated euro credit assets were available, mismatch risk would likely not be reduced much below 1.5%.
Overall, and in order to match duration and spread duration especially, a larger allocation to long-term credit could reduce mismatch as well as improve yields, helping corporate pension funds meet future liabilities.