At the beginning of 2013 there seemed to be no end in sight for the problems facing corporate pensions in the U.S. The plans of S&P 500 companies had an estimated deficit of $429 billion, and their funding ratio of assets to liabilities averaged 77.5%. However, just a year later these pensions are in much better shape. U.S. equities rallied roughly 30% and interest rates used to discount liabilities rose by around 100 basis points (bps); asset values soared while the present value of liabilities plunged. As a result, the average funded ratio is now closer to 96%, based on PIMCO’s analysis of industry reports. Such improvement is unlikely to be repeated, and several plans are working to lock in those gains. We think active management will play a crucial role, especially if market returns are lackluster in future years.
The increased focus on underfunded pensions in recent years has made de-risking a priority, with many corporations adopting formal plans to reduce asset-liability mismatches. We believe active returns (alpha) can play an important role in improving funded levels and reducing volatility. Active management in liability-driven investment (LDI) portfolios is especially critical because the long-term investment horizon of plans gives them the potential to steadily improve their funded status, not just maintain it at a certain level.
A mere 50 bps of alpha annually can translate to 7.9% of additional returns on the fixed income portion of a portfolio over a period of 10 years (assuming 5% annual returns in the asset class over that period). Moreover, fixed income alpha improves a plan’s Sharpe Ratio versus its liabilities. More details on this can be found in “Cutting Into Pension Plan Asset Allocation with a LASR.”
Figure 1 shows the impact of alpha compounded over 10 years under different beta and alpha scenarios.
Pension plans are certainly not out of the woods yet, but an investment manager’s ability to generate alpha can play a critical role in reaching key goals. By design, LDI mandates are focused on minimizing tracking error relative to liabilities. In most cases LDI portfolios comprise a longer-duration index with a mix of credit and U.S. government securities; these aim to replicate the returns of an index of AA-rated credit (which is used formally to discount liabilities). PIMCO has an experienced portfolio management team with time-tested strategies that potentially allow LDI managers to take advantage of market inefficiencies and generate alpha in tracking-error-sensitive mandates. These strategies revolve around efficient management of duration, market volatility, credit, liquidity and transaction costs, all within the context of strict risk-budgeting and controls.
In the duration space, this means positioning based on PIMCO’s cyclical and structural views on interest rates developed during our forums, the quarterly gatherings of the firm’s investment professionals from around the world. We strive to maximize total return from interest rate exposure regardless of the direction of rates. We seek to benefit from gaining exposure based on our outlook on Treasury rate curves and by focusing on maximizing returns from carry and convexity. Structural inefficiencies in the market allow us to take positions that aim to exploit valuations across different interest rate products, such as derivatives in place of cash instruments. Furthermore, our insights on market positioning and momentum allow us to be tactical and seek to manage positions around volatility in interest rates.
Managing market volatility is another important role an active manager plays. We believe markets have a tendency to both overshoot valuations and overcharge for hedges against such moves; this volatility, however, can provide opportunities. With a close eye on both fundamentals and technicals, an active manager can tactically adjust positioning and potentially benefit from these dislocations. Strategies can be simple, such as trading market ranges counter-cyclically, or more complex, such as selling volatility in the options markets when valuations are favorable or structural imbalances are present.
Credit risk can be the largest potential source of alpha and tracking error for LDI mandates. At PIMCO the investment process takes advantage of our top-down macro outlook, bottom-up micro analysis and detailed view on relative valuations. PIMCO’s macro outlook points us to sectors that could benefit and determines our positioning. Furthermore, extensive micro research and analysis by our team of 51 credit analysts enables portfolio managers to seek opportunities and avoid pitfalls in this sphere.
Our credit strategies go beyond simply selecting the appropriate industries and issuers. They encompass choosing the right maturity for debt, positioning in attractive off-index sectors, investing in appropriate crossover names and avoiding issuers with bondholder-unfriendly activities such as share buybacks, M&A transactions and activist shareholder involvement. This enables PIMCO potentially to derive excess returns from a variety of sources with the additional benefit of reduced tracking error. Not relying too heavily on one particular strategy can help mitigate large downside moves and reduce dispersions in returns from specific positions. For LDI accounts, we seek to maximize returns by carefully assigning weights to active strategies within a portfolio consistent with our view on correlations between credits and industries across different sectors.
Relative value trades across the capital structure are also an important source of potential added value in credit. Our detailed bottom-up analysis leads us to favor either more senior bonds with strong downside protection or subordinated debt with more equity-like risks embedded in them based on market valuations.
PIMCO’s credit expertise covers more than just the investment grade corporate sector that is central to LDI mandates. Our extensive coverage across markets allows us to tactically take advantage of value in off-index sectors like high yield debt, residential mortgage-backed securities, commercial mortgage-backed securities, municipals and emerging markets. Investments in these sectors that have independent cycles may provide additional diversification potential without sacrificing returns.
Finally, credit markets also have inefficiencies due to herd behavior or “index-cloning” by large numbers of investors. Since the recent financial crisis there has been a greater tendency for investors to hug their indexes. We believe this has led to increased mispricing. Issuers that are favored by indexers tend to richen beyond fundamentals, and less-analyzed issuers, industries, and market segments – with equally good fundamentals – tend to trade cheap. LDI managers with longer investment horizons are well positioned to potentially take advantage of these inefficiencies to increase returns.
Taking advantage of illiquidity in markets is something LDI portfolios can potentially do well, since they have longer-term investment horizons. The process entails investing a portion of the portfolio in illiquid assets that offer additional yield potential relative to fundamentally similar assets. Additionally, this calls for keeping dry powder to potentially take advantage of market dislocations. Market liquidity has declined since the financial crisis; increased regulation is hampering the number and size of dealer balance sheets available for providing this service. At PIMCO we carefully assess trading costs and determine the holding period necessary to compensate for this illiquidity. We also are tactical in gaining exposure, seeking to ensure that we are not being overcharged when investing.
Transaction costs, in the form of bid-ask spreads, can be a large drag on performance, especially in longer-duration bonds. Generally, the cost of transacting a 30-year corporate bond with a bid-ask spread of 10 bps is around 0.75% in price terms (5 bps on a bond with a 15-year duration), and this cost can increase significantly when markets are stressed. Furthermore, trading expertise is needed when executing larger trades to minimize costs without affecting valuations. Since illiquidity has increased in markets due to new regulations, these costs are likely to continue to rise. One has to take a longer-term view on valuations and monitor trade frequency to minimize the cost of getting fully invested.
Active management can aid LDI efficiency
Pension plans are returning to better health, and de-risking has become a primary focus of plan managers. Alpha from active management over the long run can provide a significant advantage. Not only is replicating an index difficult, but it is also inefficient and costly. Individual client objectives are the primary guide to managing LDI portfolios, but the use of appropriate and flexible alpha strategies can allow active managers to enhance return potential over the longer-term horizon. PIMCO’s credit expertise, well-thought-out outlook and strategies have the potential to help plans achieve their goals: reduced funded-status volatility and improved returns.