Nuclear decommissioning trusts (NDTs), the pools of money accumulated over decades used to dismantle nuclear power plants and safely dispose of radioactive materials, allocate about 40% of their assets to fixed income securities.^Footnote1 This is problematic, however, when NDTs have average annual after-tax return targets of 5%^Footnote2 and the yield-to- maturity of the Bloomberg Barclays US Aggregate Bond Index (BBAG) is just 1.6%. The solution, in our view, is to look beyond benchmark-oriented core bonds to a broader set of fixed income strategies.

In recent years, the pool of assets in U.S. NDTs has grown by two-thirds, from $45 billion in 2010 to nearly $75 billion.^Footnote3 Despite the dramatic growth and steady contributions by NDT sponsors, funding shortfalls have persisted as decommissioning cost estimates continued to climb. With the U.S. power-generation mix shifting away from nuclear energy and more nuclear plants starting the decommissioning process, the need for NDTs to grow assets to close funded status shortfalls has never been greater.

The portfolios of NDTs are dominated by public equities and core fixed income. At 40% of the average NDT portfolio, core fixed income (proxied by the BBAG) is a meaningful component for most NDTs. Historically, the BBAG’s starting yield has been a strong predictor of the index’s subsequent five-year annualized returns, with a correlation greater than 90%. With the BBAG yield near historical lows, PIMCO estimates that the average NDT’s fixed income allocation might return only 1% annually over the next five years, while the after-tax return of the total portfolio may be closer to 3% – well short of most NDTs’ 5% targets (see Figure 1). Assuming a 1% return from fixed income, equities in the average NDT portfolio would likely need 10% annual returns to realize a total portfolio return of 5% after tax. Given current equity valuations, though, that seems like a high hurdle.

NDT sponsors are left with few obvious choices. Increasing return potential by boosting equity allocations may bust the risk budget and feel uncomfortable. Yet making no change risks accepting intolerably low performance.

An alternative is to seek more from the fixed income allocation itself – for instance, by broadening the opportunity set of underlying strategies and emphasizing active management, which may add more value in fixed income than in equities^Footnote4 (see our Research piece, “Bonds Are Different: Active Versus Passive Management in 12 Points”). If implemented appropriately, enhancing the fixed income allocation may improve both return potential and alignment with the NDT’s projected profile of decommissioning expenses.

Barbell-shaped liability profile

We bring a liability-aware framework to our NDT investment solutions practice, one which is cognizant of the projected timing and magnitude of anticipated decommissioning expenses. While each NDT is unique, it is typical for the decommissioning process to take well over a decade to complete, with relatively large expenses required both in the early years and in the final stages of decommissioning.

Therefore, the profile of an NDT’s projected decommissioning expenses often resembles a barbell shape.

From an investment standpoint, a barbell-shaped liability profile that extends more than a decade into the future has multiple implications. First, it suggests that most NDTs (including those still in the accumulation phase and those in early decommissioning) still have a long time horizon before decommissioning is complete. This provides an opportunity to pursue more dynamic public and private fixed income strategies that target higher returns. At the same time, near- term liabilities may be more efficiently met with a customized liquidity-management strategy than a standard benchmark-oriented approach. As Figure 2 shows, an array of fixed income strategies can be tailored to an NDT’s liability and risk profiles, with underlying strategy allocations sized to match each NDT’s short-term and long-term needs.

NDT fixed income strategies

Here’s a look at how three fixed income strategies have the potential to help NDTs close funding shortfalls:

Multi-sector fixed income may enhance flexibility and yield

Relative to passive and benchmark-driven core bond strategies, an active multi-sector approach increases the breadth of the investable universe and the ability to pursue opportunities as they arise. Portfolio yield may be increased by selectively incorporating non-core market segments with attractive risk-adjusted return potential, such as high yield, municipals, and emerging markets (EM) bonds. For example, an equally weighted blend of investment grade, high yield, and EM debt currently yields 3.4%, more than double the yield of the BBAG.^Footnote5 The additional flexibility in active multi-sector strategies may also enhance returns by capturing tactical opportunities following market dislocations, as we saw after the COVID-19 crisis in March 2020. While higher-yielding strategies may introduce a modest step-up in volatility relative to core bonds, in our view the incremental return potential outweighs the risk differential, particularly given NDTs’ target return objectives.

Private credit increases long-term return potential

For NDTs with a sufficiently long investment horizon and guideline flexibility to incorporate greater risk and less liquid investments, private markets provide a distinct slate of opportunities, enabling investors to target a liquidity premium and higher returns. Among private market investments, our research^Footnote6 indicates that private credit has generated higher and more consistent alpha than private equity, and offers better diversification potential. As Figure 3 shows, there is limited risk factor overlap between broad private credit strategies and the traditional stock and bond exposures that dominate most NDT portfolios. Furthermore, broad private credit strategies may help NDT sponsors reduce risk relative to equities over time, while targeting greater and more consistent income.

Custom liquidity management can help address near-term liabilities

Meeting shorter-term decommissioning expenses efficiently is also critical. In today’s environment, holding significant excess cash to cover near-term liabilities creates a drag on returns.

Similarly, funding liquidity needs by repeatedly rebalancing out of benchmark-oriented bond or equity portfolios is undesirable due to transaction costs and taxes. To address near-term liabilities more efficiently, NDT sponsors can consider a customized cash flow driven investment (CDI) approach designed to match the timing and magnitude of projected decommissioning expenses. In addition to potentially yielding significantly more than cash, a well-constructed CDI portfolio may naturally generate cash flows to meet decommissioning payments.

For NDT sponsors that wish to maintain an allocation to short- term fixed income but are not certain enough about upcoming decommissioning payments to adopt a CDI approach, focusing on active management remains key, in our view. Particularly with money market rates near zero, alpha potential from active short-term strategies may be more meaningful because it will often represent a much larger portion of the investment’s overall return.

The way forward

Looking ahead, NDT sponsors are likely to face a challenge achieving target return objectives given current capital market valuations. However, we see multiple opportunities to improve return prospects by refining the fixed income strategy, which represents 40% of the average NDT portfolio. While many NDTs rely primarily on benchmark-oriented core bond strategies, a more nuanced approach may be better suited to NDT objectives. In particular, higher-yielding multi-sector strategies and private credit may boost long-term returns to meet long duration liabilities, with shorter-term expenses covered by more efficient liquidity management strategies such as CDI. Together, these strategic opportunities may increase NDTs’ estimated returns and provide greater scope for alpha potential. As NDTs prepare for and start executing their decommissioning plans, active management could be increasingly important.