External influences are constantly reshaping American businesses, which either adapt to the changing environment around them or risk extinction. The gasoline shortage and oil crisis of the 1970s, for example, combined with technological advances in the manufacturing of jet airplane engines, led to the elimination of some overbearing regulations in the airline industry, which increased competition and ultimately lowered transportation costs for consumers.
In our view, high government debt levels, greater volatility and low return expectations will force pension plans to make adjustments similar to the forces that encouraged change in the airline industry. For example, while most plans have guidelines that strictly limit the amount of exposure the plan might have to emerging markets, changing global growth dynamics are encouraging a fresh, new look at allocations to this asset class.The rules and investment policies that currently guide investment decisions are likely to be challenged by the conditions mentioned above, in particular:
These issues are all related to the higher debt levels in many developed countries and better initial conditions for select emerging market countries.
Accounting for willingness and ability to payAs most pension plan administrators know, duration is a linear approximation of the sensitivity of a bond to changes in interest rates. For example, the price of a bond with an effective duration of two years will rise two percent for every one percent decrease in its yield. Pension plans rely heavily on such linear estimates to assess the sensitivity of both their assets (investments) and their liabilities (retirement claims). However, on the asset side of the plan’s investments, investors need to be aware that their durations may be “overstated” due to an assumption used by most index providers – namely, that coupons and principal are actually paid in accordance with the security details. Markets are challenging this assumption with certain European sovereigns, which used to be viewed as being essentially void of default risk.
One of the attributes used to account for the likelihood that coupons and principal are paid on time is debt relative to the income a country or company can generate to pay those claims. John Maynard Keynes, the acclaimed British economist, captured this attribute well in the early 1900s when he said, “Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed.” In other words, when the debt stock becomes relatively high, it becomes increasingly questionable as to whether the issuer will be willing, or in some cases able, to pay creditors. Given the amount of debt in the government sector in several advanced economies, what used to be considered pure interest rate duration is taking on characteristics of credit risk. This means that investors need to incorporate more of the issuer’s willingness and ability to pay into their risk assessments.
How CDS affect duration calculations Factoring in the likelihood of default and recovery implied by market measures such as credit default swaps (CDS) can cause a meaningful change in duration. For example, consider a bond with an annual coupon and one-year maturity issued today. If the bond has no default risk, then it has a one-year duration. Let’s say, however, that the CDS hypothetically implies a 10% chance of default within the year. When we adjust the duration to reflect this new weighted probability implied by the CDS, the duration (default risk) adjusts to .92 years rather than the one year we started out with.
This illustration is simple because it uses an annual pay coupon with a one-year maturity. When applying the same type of analysis to the securities held in a portfolio, or for the various indexes that are often used in fixed income markets, the adjusted results can be even more dramatic.
For example, we believe that the duration for the Barclays Government Credit Index and the Barclays Credit Index may have been overstated by more than ¾ of one year to 1.4 years respectively, using market implied default measures at the end of the third quarter of 2011. The reason we believe duration is actually lower than most data services and indexes provide is that we incorporate the default risk for all of the securities in the indexes and apply a factor to their coupons and principal payments to reflect the chance that those cash flows will not be received. In other words, as default risk increases, we believe duration calculations should factor in the probability that some payments of coupon or principal will not be paid.
Some observers may argue that a bond’s yield already reflects a discount for default risk, and therefore there is no need for additional consideration for default risk when reassessing durations. But we believe that when we factor in the (low) probability that principal and coupons will be paid until maturity, duration is significantly lower. Figure 1 illustrates why this issue is more relevant today than it has been in the past. Let’s assume we are looking at the assets and liabilities of a company, where the base case for asset growth is the dark blue line and liabilities are in red. The orange dotted forecasted lines represent two ranges of outcomes, a lower and a higher range of volatility in an asset.
The shaded triangle in Figure 1 focuses on the area of a normal distribution and one with fatter tails to illustrate where the default probability is extremely likely because the assets have fallen below the value of the liabilities (i.e. negative equity). While, overall, the probability of default is relatively small, as highlighted by the probability distribution to the right of the shaded region, an increase in volatility increases the probability of default, which impacts the cost of capital. When looking at the balance sheets of select corporates or applying similar logic to sovereign securities, the likelihood of default increases substantially in periods where debt levels and uncertainty or volatility in the business are high (change in value of assets). As a creditor, this logic helps drive the cost of capital. In today’s markets, this also helps to explain why we believe duration on the investment side of many portfolios’ plan assets is probably lower than most plans estimate.
This is in contrast to the liability side of the pension plan. While pension liabilities are discounted using a credit curve, either AA or A or better depending on whether we are discussing accounting or funding liabilities, here the duration is affected by the higher spread but not the default probability adjustment to the cash flows. This is because the yield curves used for discounting drop the reference credits when they fall below the required rating levels. As such, plan sponsors need to consider the composition of asset and liability credit compositions carefully and realize that although a portfolio may seem to be duration- and credit-matched, in reality it may not be.
The credit allocation return could be higher than traditional fixed income allocations given credit’s higher equity beta, while the duration in credit could further serve to reduce the volatility around the plan’s liabilities, thus reducing overall plan or surplus volatility.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Credit default swap (CDS) is an over-the-counter (OTC) agreement between two parties to transfer the credit exposure of fixed income securities. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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