Many corporate sponsors of defined benefit (DB) plans using liability-driven investing (LDI) strategies are facing a new challenge – the need to navigate late-cycle economic dynamics and a possible recession. Although we don’t expect a downturn in the immediate future, our Secular Outlook foresees recession over the coming three to five years. Moreover, the Bloomberg Barclays U.S. Long Corporate Bond Index has undergone a major shift over the past decade, with ballooning issuance and a shakeup in quality. In our view, an active approach to managing LDI portfolios, supported by significant and flexible investment resources, will be more essential than ever.
Many, if not most, LDI investors will be navigating late-cycle dynamics for the first time. Although PIMCO has managed LDI mandates for decades, these strategies became widespread only after the 2008 financial crisis following the implementation of new funding and accounting rules a few years earlier.
The challenges are already apparent: Since 2009, the Bloomberg Barclays U.S. Long Corporate Bond Index has almost tripled to over $1.5 trillion in market value. Perhaps more important, the share of BBB rated debt has jumped from less than 40% to about half of the index during the same period. The surge of issuance and deteriorating credit quality are hallmarks of late-cycle dynamics – and, we believe, a reminder of the potential benefits of taking an active approach to LDI.
Managing LDI portfolios: 2018 and beyond
In light of these structural changes in the U.S. Long Corporate Bond Index, the skills and capabilities required to succeed in actively managing LDI assets today have evolved substantially from those that were needed in 2009. As Figure 1 shows, the notional value of the universe has nearly tripled on the back of a 44% increase in the number of issuers and a doubling of the number of issues.
A significant increase of this sort in the number of issuers will certainly put the depth of an investment manager’s credit research capabilities to the test. In our view, managers that enjoy substantial scale and deeper credit research resources will find it easier to adapt to the new environment and may be better positioned to outperform going forward. Our recent Bond by Bond videos elaborate on our research techniques: “Prepared to Act in Every Market” offers an overview of our credit team’s approach to generating and researching new investment ideas, and “Finding Rising Stars in Housing” shows how PIMCO’s independent credit research process has driven our positioning across the housing sector.
Flexibility and malleability of the credit research structure is also an important element that can help an active manager address new market realities. In particular, research teams that avoid artificial boundaries between credit ratings (investment grade, IG, versus high yield, HY), maturities (intermediate versus long term) or geography can reorient and reallocate resources more easily to address the changing composition of the market.
Another consideration is the potential for reduced diversification (and therefore higher risk) within the long corporate bond market – as correlations tend to increase in late-cycle environments. An active LDI manager can potentially overcome this incremental risk through astute security selection, including by steering portfolio allocations toward long corporate issues that have more stable diversification properties. Making moderate and risk-mitigating off-benchmark allocations also has the potential to help active LDI investors better manage concentration risk.
Passive approaches implicitly favor quantity over quality
BBB rated corporate bonds now account for approximately half of the U.S. Long Corporate Bond Index, compared with about 40% in 2009 (see Figure 2) and even less prior to the 2008 crisis. This is significant when one considers that, as shown in Figure 3, the probability of downgrade to HY for BBB bonds was five times that of A rated issues. Maybe more important, 27% of the long corporate bond market is either BBB or BBB-, the two lowest investment grades above high yield. In January, our colleagues Jelle Brons and Lillian Lin detailed the evolving corporate bond landscape in “Investment Grade Credit: Be Actively Aware of BBB Bonds.”
While simple index replication might have worked as the economy was recovering, we believe that the aging of the current cycle and the decline in the credit quality of the index create the potential for elevated downgrades and an increase in negative outlooks that could have adverse price effects. A passive approach to building and managing credit-heavy LDI portfolios ignores these new and increasingly important characteristics of the index.
On the other hand, an active management approach can potentially take advantage of these structural changes to sustain, and even enhance, relative performance. Indeed, underweighting weaker or overvalued credits may be as significant a source of alpha as investing in strong and outperforming companies.
Why does this matter for LDI investors?
Some investors question the merits of active management in LDI. Their reasoning revolves around the idea that LDI is a risk-reduction strategy and therefore the amount of active risk in an LDI portfolio should be limited (e.g., with passive or low active risk/low alpha target approaches).
We have a different view. In fact, even a well-constructed passive LDI strategy would have lagged the liability it seeks to match by between 40 basis points (bps) and 85 bps annually over the last five to seven years (see Figure 4). Among other reasons, this reflects how discount rate methodologies effectively ignore the impact of downgrades, while passive portfolios feel the full brunt of it. In other words, liability discount rate methodologies implicitly assume that LDI portfolios are managed actively by presuming that they avoid exposure to any downgraded bonds. Therefore, we strongly believe that a meaningful amount of active management is required for LDI investors in seeking to achieve their objective of closely matching liabilities. Because completely eliminating exposure to rating downgrades within an actively managed LDI portfolio may be unrealistic, impractical or even undesirable, we suggest employing a broader and diversified approach to active management that will pull on a number of levers to achieve its excess return objective (security selection, sector rotation, credit quality management, interest rate risk management, moderate out of benchmark allocations, exploiting market inefficiencies and anomalies, etc.).
Figure 4 shows how passively managed LDI portfolios significantly underperformed liabilities over the past five and seven years – a period, it’s important to note, that was relatively constructive for credit markets. The future may be even more challenging for passive or low active risk investors if we are indeed in the late stages of the current cycle.
Security selection used to be associated first and foremost with equity strategies. However, while the number of listed equity securities has dwindled over the last 20 years (the Wilshire 5000 Index, for example, has fallen to fewer than 3,500 stocks compared with over 7,500 in the late 1990s), fixed income credit markets moved in the opposite direction – leading to a burst in both the size and number of opportunities in the market.
As we enter the late stages of the economic cycle, the rapid increase in the size of the long corporate bond market, its number of issuers and issues, as well as a decline in average credit quality, will likely present significant challenges for passive or low active risk investors, potentially exposing them to undue price and downside risk.
Active management does not guarantee future results, but it does offer an opportunity to take advantage of this new market structure without compromising on LDI’s hedging objectives.