Updated August 2023 – It’s no secret that things have been rocky in the financial markets. The Fed is raising interest rates and shrinking its balance sheet to help control inflation, the cost of borrowing has increased and earnings for many organizations continue to decline
Plans that have a Liability Driven Investment (LDI) strategy have most likely fared well as higher interest rates and wider corporate bond spreads have driven reductions in pension liability values in 2022. These reductions have in most cases offset investment portfolio losses. However, if the economic situation continues to deteriorate, leading to a more challenging corporate credit environment, we see the potential for unexpected losses and frustration on the part of plan sponsors. With that potential comes an opportunity that plan sponsors should not overlook.
This article explores what could go wrong for plan sponsors that employ LDI strategies and what they should be thinking about to try to manage this risk.
Matching Assets to Liabilities
Corporate pension plans value their liabilities using yields based on high-quality corporate bonds. Many pension plans use derived yield curves like the FTSE Pension Discount Curve as the basis for these calculations. While these curves are great for coming up with a market-related value of yields, the curve itself isn’t actually investable.
Because these yield curves are not investable, investment consultants and managers will help construct liability matching fixed income (i.e., LDI) portfolios that attempt to mimic the behavior of a pension liability based on this yield curve model. This typically involves the use of a number of different instruments like Treasury securities (both STRIPS and par bonds), corporate bonds of various credit quality, and high-yield bonds to achieve the right match in yield, duration, convexity, etc.
Here’s the Problem
The yield curves that are constructed to value liabilities are based on a universe of high-quality, investment grade bonds. If a company that is in this universe starts to struggle, increasing its risk of bankruptcy, then the yield on its bonds relative to Treasuries or bonds of companies that are not struggling will widen. At first, this is a good thing for a pension plan sponsor – higher yields mean lower liability values.
But if a bond drops far enough in quality (for example if it is “downgraded” sufficiently) then it will be removed from the universe and will no longer factor into the yield curve calculations. The liability discount rate can drop suddenly, especially if a number of bonds drop in quality all at once as has happened before in recessions. On the asset side, if a pension plan is holding the bonds whose yields widened, that negative performance shows up in lower asset values.
Bond downgrades have the potential to cause unexpected funded status losses as they are removed from the liability calculation but continue to affect asset values. In times of economic uncertainty, the possibility of downgrades increases. If that happens on a large scale, it’s not unfathomable that pension plans could lose meaningful ground on an LDI strategy that plan sponsors thought was protecting the plan from adverse interest rate movements. This is exactly the situation plan sponsors found themselves in during the Great Financial Crisis when many financial sector bonds were downgraded and plans lost ground due to the mismatch in their liabilities and assets.
What Should Plan Sponsors Do Now?
Pension plan sponsors should evaluate whether the risk in their LDI portfolio makes sense. For many sponsors, that means looking at whether the amount of risk in credit (i.e. corporate bonds) is appropriate or if a higher allocation to higher quality credit, or to government bonds might be a better option.
This issue is even more critical for pension plan sponsors going through the plan termination process, as downgrades or defaults can lead to unexpected contributions when the liabilities are settled.
Increasing exposure to higher quality corporate bonds, or to US Treasuries versus broad quality corporate bonds can reduce downgrade risk and position the plan to benefit if credit spreads continue to rise. At a later point, the reverse can be done, locking in the potential for higher returns. Having an advisor to help manage this strategic risk management process is critical to supplement the more tactical strategies employed by active fixed income managers.
Hire Strategic Consultants you can Trust
Navigating the challenges posed by the current economic landscape, especially in the context of managing a pension’s LDI strategy, requires both vigilance and proactive thinking. The lessons from the past emphasize the potential repercussions of unexpected bond downgrades. As the tide of the financial market continues to ebb and flow, plan sponsors must seize the opportunity to fortify their LDI strategy.
At Agilis we can be your consulting advisor to help navigate these complex waters. The integrity of your pension plan’s future may very well depend on the strategic choices you make today. Act now to safeguard and optimize your LDI strategy amidst these challenging times. Call us today!