Most liability-driven investing (LDI) portfolios deployed by private defined benefit plan sponsors combine long-dated credit and long government (or Treasury) bonds. The optimal weighting of these components depends on several plan-specific factors, including the nature of the plan’s discount rate methodology, its asset allocation, and the duration and curve exposure of its liabilities. Whatever those weightings may be, the decision to combine credit and government bonds in blended LDI mandates (the bundled approach) or to separate them into sector-specific mandates (the unbundled approach) is among the most consequential decisions plan sponsors have to make.
As we wrote last year in “The Great LDI Paradox: Long Government Bonds and Active Management,” bundled LDI approaches are likely to lead to superior outcomes relative to a collection of disparate unbundled mandates. Today’s interest rate environment, heralded by sub-1% 10-year Treasury yields, only reinforces that case. Indeed, by blending Treasury allocations with credit exposures in an integrated actively managed LDI portfolio, plan sponsors may be able to unlock a substantial amount of alpha potential to supplement relatively low returns expected from Treasury bonds. This, in turn, can help plan sponsors access the benefits generally associated with long-dated Treasury bonds – including downside risk mitigation, liquidity to source benefit payments, and better alignment of LDI credit quality exposure with liability discount rates – while significantly reducing the very high opportunity cost currently associated with owning long Treasury bonds.
Treasury yields are at historically low levels and there is a growing realization that return prospects for those instruments should be meaningfully lower going forward (see Figure 1).
That said, many corporate defined benefit plans will continue to own long Treasury bonds to address other objectives. These include:
- Providing downside risk mitigation and diversification of return-seeking allocations
- Aligning overall credit risk of the LDI portfolio with that of liability discount curves
- Achieving duration hedge ratio targets
- Supplying liquidity for benefit payments or rebalancing needs, especially during challenging markets
However, the cost of accessing these benefits is meaningfully higher than it’s been historically; investors are now being paid only a 1.5% yield on a passive exposure to the Bloomberg Barclays US Long Treasury Index. Realized returns are likely even lower once management fees and transaction costs associated with maintaining an index-like exposure are factored in. This puts investors in the highly undesirable position of paying more (i.e., accepting a lower yield) for what will likely be materially reduced benefits going forward (as there is less potential downside risk mitigation from here).
Keeping it bundled may lead to better outcomes
Fortunately, LDI investors need not accept this fate and can seek to improve this trade-off by bundling their LDI portfolios. Augmenting the yield on Treasury holdings through the use of active management may reduce the price to access the advantages offered by these bonds, bringing costs closer to what plan sponsors experienced and were comfortable with over the last decade. For example, an additional 1% to 1.5% on top of the current long Treasury yield would amount to a combined “yield + alpha potential” in the range of 2.5% to 3.0% (versus the inadequate 1.5% yield currently offered by long Treasury bonds). However, achieving this requires excess returns on the long Treasury holdings on the order of 100-150 basis points (bps). That task may appear daunting given that dedicated Treasury bond exposures are often implemented passively – the rationale revolving around the belief that the ability to generate excess returns by actively managing long Treasury bonds is limited. This is where bundling may be advantageous to plan sponsors.
It may be true that the prospects for adding value when managing long government bonds in isolation are limited. With the lack of credit risk and a finite set of issuers, the manager certainly has fewer levers to pull. However, when those bonds are instead part of a bundled portfolio that includes a significant share of non government holdings, like a long government/credit portfolio or a customized LDI portfolio, an active manager like PIMCO can seek to achieve an alpha target commensurate with that of an actively managed LDI strategy on the entire amount invested in that portfolio, including the dollars invested in long government bonds.
In other words, we can effectively implement the same top-down and bottom-up active positioning, both directionally and in magnitude, whether the actively managed LDI portfolio benchmark is 50% credit/50% government, 75% credit/25% government or 100% credit (or any other combination with a sufficient amount of credit exposure). That is, if we want to be 2% overweight a certain issuer, 1% underweight another and run a longer-duration posture by 0.5 years, we can implement that positioning in any of the portfolios above and ultimately seek the same excess return. On the other hand, when a plan sponsor manages long government bonds passively or in low-discretion fashion in an unbundled framework, they forgo a large portion of the alpha potential on the dollars invested in Treasury bonds. Therefore, as Figure 2 shows, bundled LDI approaches are likely to be more efficient and may help plan sponsors overcome the drag associated with lower yields.
Management fees and other considerations
Proponents of the unbundled approach will often point to the potential to save active management fees. It is well-known that passive (or low discretion) long government mandates typically carry a management fee that is significantly lower than that of actively managed LDI portfolios. However, the potential fee savings need to be considered in light of the forgone alpha potential. For example, even if a plan sponsor were able to achieve, say, a 20 bps reduction in management fees on the unbundled Treasury bonds (arguably an aggressive target), this would amount to only 10 bps of savings on the total portfolio (in our example above). In comparison, forgone excess returns amount to 80 bps in the example above. In the end, for every $1 dollar of potential fee savings achieved through unbundling, the plan in this hypothetical example may give up approximately $8 in excess return. (Although active managers cannot guarantee positive alpha at all times, passive managers are virtually guaranteed to deliver none.)
In addition, unbundled approaches are generally more resource intensive for plan sponsors to manage: They require constant rebalancing of the two separate long credit and long government mandates toward the target mix as markets fluctuate. That rebalancing activity will also generate transaction costs that may add up over time in volatile market environments. Both of those issues can be managed and diminished with a bundled LDI approach.
Historically low interest rates create a host of challenges for defined benefit plan sponsors. One is the dilemma with long-dated government bonds. While these instruments have very low yields and return prospects, they still check the box on a number of objectives that may be imperative to many plan sponsors – e.g., downside risk mitigation, liquidity, and fine-tuning alignment with discount rate credit quality.
However, this trade-off can be greatly ameliorated by bundling long government bond allocations with long credit allocations in actively managed portfolios. In so doing, plan sponsors can expose government bond dollars to the same alpha potential as credit portfolios (instead of the passive/no-excess-return implementation associated with unbundled long government bond allocations).
Bottom line: Improved return potential on those bonds could help investors access the benefits of long government bonds at a lower cost than that implied by current low yields. That, in addition to possible operational advantages, lower transaction costs and more straightforward rebalancing, makes a strong case for bundled government-credit portfolios in LDI.