[JARED INTRO]

Hi, I’m Jared Gross, Head of Institutional Portfolio Strategy.

Over the last decade, pension strategy has become increasingly focused on reducing risk and matching liabilities across time.  The success of this model – known as Liability Driven Investing, or LDI – has generated momentum to keep pushing further in the same direction, even as the risks in this approach are starting to become visible.

[Insert chart of pension allocations]

A course correction is in order. 

Bond-heavy asset allocations are less able to earn their way past funding shocks.  Portfolios concentrated in corporate credit are vulnerable to downgrades and defaults that don’t reduce the liabilities they are hedging.  And the use of Treasuries as the sole diversifying asset locks in negative carry and low forward looking returns. 

Saving LDI from itself may be the next phase of pension asset allocation.

 There is a practical solution to the problem of concentrated hedge portfolios with limited diversification and low return prospects.  Fortunately for investors, this requires only two modest changes:

• first, that pensions bring back into their investment program an asset class that was once commonplace: securitized fixed income; and,
  
  
• second, that they recognize a shift in the securitized market over the past decade that has allowed a new type of hedge asset to emerge.

The benefits of our approach include better diversification and reduced concentration risk, improved resiliency in a market sell-off, and higher income and risk adjusted returns.

I’m joined by Justin Rucker, a senior fixed income portfolio manager specializing in long duration and securitized strategies. So, Justin, let me turn to you and ask:

“If securitized investments are a natural fit for liability driven investment strategies, why haven’t investors been using them all along?”

[JUSTIN RESPONSE]

Thanks Jared.

Let’s start with just a little bit of history.  Prior to the widespread adoption of LDI, most pension funds invested in core fixed income programs that had 35-45% in securitized bonds.  So this is definitely NOT a new asset class.

Unlike core bond investing, which is fundamentally about building a portfolio that provides stability, income, and diversification to equities, liability-driven investing seeks to hedge very specific risks arising from the mark-to-market volatility pension liabilities.  While there is no perfect hedge, the key attributes that investors are looking for are high credit quality, long duration and yield.  Portfolios of corporate bonds and Treasuries suit this purpose.  Many securitized assets, on the other hand, offer low duration and negative convexity – making them difficult to line up with liabilities. 

And let’s remember that, at the time when most investors were starting down this path, the small size of hedge portfolios meant that risk mismatches to the liability were insignificant and the level of corporate spread was high enough to compensate.  Fast forward: NOW the hedge portfolios dominate the asset allocation and the level of yield available is at all-time lows.  What seemed like a closely matched asset at first is starting to feel a bit riskier.

[Insert chart of agency CMBS market growth]

Interestingly, while LDI investors were focused elsewhere, the securitized market evolved in ways that made it increasingly suitable for liability hedging.  Developments in multi-family property financing created new classes of super-high-quality bonds with long durations and attractive yields.  The size of this asset pool is now well north of $800 billion dollars.  Interestingly, that’s about the same size as the long corporate bond market at the time of the Great Financial Crisis – just when investors started ramping up their LDI portfolios.

[JARED]

So the timing is now right for pensions to re-enter the securitized market.  Traditional LDI assets are not compensating investors for the risks they are taking and the availability of long duration securitized bonds presents an attractive alternative. 

Let’s spend a moment on the fundamentals.  We know that a pension asset should offer three broad attributes: quality, duration and yield.  How do long duration securitized bonds deliver on these characteristics?

[JUSTIN]

Let’s start with quality. 

[Insert Quality box / bullet]

These are securities backed by high quality assets – typically multi-family residential properties that participate in various GSE credit facilities, such as the Fannie Mae DUS program.  As a result, they are principal guaranteed and effectively default remote.  Of course, we spend the time to understand the underlying assets and the deal structure to ensure that our investors’ interests are protected.

Next is the duration.

[Insert Duration box / bullet]

The rap on traditional mortgage securitizations is that they embed optionality around refinancing that leads to short duration and negative convexity – the exact opposite of what a pension liability hedger needs.  The types of deals that populate the long securitized space contain strong prepayment and yield maintenance provisions that create long duration and positive convexity – precisely what IS needed for pension hedging. 

Finally, yield.

[Insert Duration box / bullet]

Compared to credit spreads, which are compensating investors for direct losses from credit risk exposure, the spreads earned on long securitized assets are essentially compensation for complexity.  If a manager understands how to value these securities and can build out a diversified portfolio, then the full spread is earned by the investor.  Loss adjusted yields are frequently close to those on long corporates, and can be higher – particularly in times of credit volatility.

And it is critical to understand that it is in times of credit volatility when Long Securitized assets show the value of high quality.  The tracking error that emerges during a credit sell-off is a direct benefit to investors – preserving capital that can be used for benefit payments or redeployed back into corporate credit at more attractive entry points. 

[JARED]

So, keeping these attributes in mind, how would you build out a long-securitized focused portfolio today?

[JUSTIN]

It’s important to recognize that, with long securitized assets serving as the bedrock to the portfolio, incremental allocations to other securitized credit sectors can be added to enhance diversification and yield, while treasury futures can be used for capital-efficient duration targeting.

[Insert table of opportunity set]

The core elements are Agency CMBS and CMO securities, which provide long and stable duration, positive convexity, and attractive yields.  To gain some additional yield and diversification, smaller positions in non-agency mortgages, asset backed securities and other shorter duration instruments would be added.  Finally, to achieve a specific duration target, treasury futures can be added along with a small amount of cash collateral.

Collectively, this portfolio would offer AA quality with a duration of 15-16 years and a yield that tracks closely to high quality corporate bonds.  It’s potential as a liability hedging asset should be clear.

[JARED]

Investors should think about introducing and managing an allocation to long securitized bonds.

Beyond the basic benefits of the asset class as a diversifying component of hedge portfolios, there are usually three main questions that come up:

• First, how much long securitized makes sense?
  
  
• Second, do I need a dedicated strategy?  And,
  
  
• Third, should I just focus on the long securitized sector
  
  

Research suggests that the optimal level of long securitized relative to long corporates is approximately 20%.  Interestingly, this seems to be backed up by an examination of the general account holdings of insurance companies in the annuity underwriting business, who hold on average about 20% in securitized assets.  Across time it is likely that the percentage will change as the markets move and various components of the hedge portfolio become more or less attractive on a relative basis.

The purpose of a dedicated strategy is to create structural diversification within the hedge portfolio, not simply increase tactical flexibility for managers operating against more traditional benchmarks.  A dedicated portfolio allows long securitized to function alongside corporate credit and Treasuries as the “third leg of the stool” in a diversified hedge portfolio.  Further, the specialized expertise required to effectively manage portfolios in this space is not broadly shared across the fixed income community.

Finally, the specific nature of long securitized assets is key to their success.  Because they have all of the essential characteristics needed for liability hedging: quality, duration and yield – they can serve as a core component of the hedge portfolio.  Broader expressions of securitized assets would require aggressive duration hedging and liquidity management just to meet these basic criteria, and whatever alpha might be generated would be given back from lower yields and higher tracking error.

[pause]

So, as the pension hedging continues to grow and evolve, the need to reevaluate LDI strategy becomes increasingly important.  The time to diversify LDI portfolios is NOW – when both credit and Treasury portfolio are rich and the benefits of flexibility are high. 

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