“Securing” Corporate Pension LDI Diversification
Don’t put all your eggs into one basket is a familiar idiom that has been around since the 17th century (and is especially fitting around early April). Similarly, the concept and benefits of diversification across asset classes when constructing a portfolio are also well-known. By investing in a variety of asset classes with different characteristics, portfolio returns can be increased, volatility can be reduced, or both. The concept of diversification can also be applied within a single asset class. For example, an equity allocation can be diversified by selecting investments with different styles (growth, value), market capitalization (large cap, small cap), and geographic focus (domestic, international developed, emerging markets).
When it comes to fixed income allocations, there has traditionally not been as much focus on diversification, especially within liability hedging portfolios for corporate pension plans. This could be due to the main focus of liability hedging portfolios matching the liability characteristics or due to the historically smaller allocation to fixed income. However, now that the fixed income allocation is approaching 50% of total pension assets, there is increased scrutiny on the composition and effectiveness of liability hedging portfolios. This trend is being reinforced by the high allocation to corporate bonds within fixed income allocations combined with an economy still recovering from the COVID-19 crisis, leading to increased interest in investments that have to date played a smaller role in Liability-Driven Investing (LDI) portfolios.
Diversification across Asset Classes
Broadly speaking, the main asset categories pensions invest in are fixed income, equities, and alternatives. These asset classes have different underlying drivers of return and risk, contributing to overall portfolio diversification. The allocation to fixed income has grown the most, increasing by over 13% of the total assets during the past decade (see Figure 1).
Figure 1: Asset Allocation
Looking at the two largest asset classes, the main purpose of equity allocations is to generate returns while most fixed income allocations tend to be long duration and are more focused on offsetting a portion of the liability risk exposure. The largest sector allocations within fixed income allocations are corporates and Treasuries, and each of these sectors exhibits a different correlation profile to equities.
Long credit excess returns are returns in excess of duration matched Treasuries and are the returns received for taking on credit risk. These returns have a relatively high correlation to equity returns. Looking at rolling 12-month correlations on a monthly basis, all but one monthly observation over the past 20 years (around the time of the Federal Reserve’s taper tantrum in 2013) had positive correlation. The correlation was 68% over the last 20 years.
Long Treasuries have been considered a ballast for portfolios, providing an offset to equities and other return generating assets at times of drawdowns. The correlation between long Treasury and equity returns was -32% over the last 20 years as of February 2021. However, the correlation can break down and turn positive when pensions need it most. The period in the past 20 years with the highest positive rolling 12-month correlation and longest stretch of positive correlations was in 2009, in the aftermath of the Great Financial Crisis, when trailing equity returns were negative. With Treasury yields still close to historic low levels reached in 2020, some investors are questioning whether Treasuries will continue to provide the offset to return generating assets that they have in the past.
Figure 2: Rolling 12-month Correlations to S&P 500 Returns
Diversification within Fixed Income Allocations
The broadest commonly-used long duration benchmark is the Long Government/Credit Index. The main sectors within this index are corporates and Treasuries & government-related, which were relatively close to equally weighted at the end of 2020. This bears a striking resemblance to the sector allocations within fixed income for the largest 100 pension plans, with corporates making up a little more than half and Treasuries & government-related being the next largest allocation.
Figure 3: Fixed Income Sector Allocation
Long Treasuries can diversify corporate bond allocations, similar to how they can diversify equity allocations. The correlation of their returns to long credit excess returns was -39% over the last 20 years. The two most recent annual time periods with positive correlations were around the 2013 Fed taper tantrum and the Great Financial Crisis (see Figure 4).
Figure 4: Rolling 12-month Correlations to Long Credit Excess Returns
With Treasuries offering such low yields by historical standards, the prospect for returns in futures years is similarly depressed. This is leading pensions to seek fixed income investments with the diversifying characteristics of Treasuries, but with a higher expected return. In order to have a higher expected return, such investments would need to include some sort of credit spread. And to be a diversifying investment, the credit spread would need to not directly come from corporate exposure. Long duration securitized assets meet both requirements.
Figure 5 illustrates the correlation of long securitized investments to both long Treasuries and long credit excess returns. Since early 2001, the correlation to long Treasuries was 84% and was -24% to long credit excess returns. The long securitized investments illustrated here have a high spread duration, currently around 10 years, but include a duration overlay in order to close the interest rate duration shortfall to long corporates for the sake of this illustration.
Figure 5: Rolling 12-month Correlations to Long Securitized
Investors seeking a high quality investment with higher expected return than Treasuries but with the potential to diversify a concentration in long corporates should consider looking further into long duration securitized assets. Long duration agency collateralized mortgage obligations (CMO) and commercial mortgage-backed securities (CMBS) can form the backbone of a strategy diversifying long corporate credit spreads. These assets are AAA-rated and include a credit spread above Treasuries. As illustrated above, they have the desirable characteristics to diversify LDI allocations – namely a high correlation to long Treasuries and a low correlation to long credit excess returns. These investments are not represented in standard long duration benchmarks but yet there is a variety of types of investments available in this space for experienced managers to uncover attractive opportunities.
For a further discussion of how long securitized assets can be used in LDI portfolios, see the following paper: https://am.jpmorgan.com/us/en/asset-management/institutional/investment-strategies/liability-driven-investing/potential-benefits-of-long-securitized-assets
The value of investments in mortgage-related and asset backed securities will be influenced by the factors affecting the commercial real estate market and the assets underlying such securities. The securities may decline in value, face valuation difficulties, become more volatile and/or become illiquid. They are also subject to prepayment risk, which occurs when mortgage holders refinance or otherwise repay their loans sooner than expected, creating an early return of principal to holders of the loans. Diversification does not guarantee investment returns and does not eliminate the risk of loss.