Jared Gross: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence in an audio podcast that provides educational insights across asset classes and investment themes. Today's episode on pension hedging has been recorded for institutional and professional investors. I'm Jared Gross, Head of Institutional Portfolio Strategy and guest host of the Center for Investment Excellence. With me today is Kay Herr, Head of Fixed Income Research, and Lisa Coleman, Head of the Global Investment Grade Corporate Credit Team. Welcome to the Center for Investment Excellence.
Kay Herr: Thanks for having me.
Lisa Coleman: Thanks for having me too Jared.
Jared Gross: Today's discussion will focus on pension hedging strategy, how it's evolved over the last several years and how it needs to continue to evolve LDI portfolios are going to meet their long term objectives. Let me begin with a little bit of background.
Liability driven investing has now become the dominant investment model for corporate pension funds. As a result, fixed income portfolios have grown as a percentage of plan assets, and at the same time, these fixed income portfolios have become increasingly concentrated in long term investment grade corporate bonds.
Now the problem is that while an LDI portfolio effectively hedges most of the risks in a liability, it fails to account for one specific risk that is becoming increasingly visible in the credit markets, specifically the risk of downgrades and defaults out of the investment grade universe into high yield.
With the overall credit quality of investment grade declining across time and with credit spreads at historically high levels, we need to be very thoughtful about how we manage this exposure. Fortunately, there are solutions. I see two promising methods to adapt LDI portfolios to make them more resilient in the face of credit rating migration.
The first method, which is not the focus of today's call, but which I will mention in brief, is to position defensively by moving a portion of the long credit portfolio to ultra high quality, triple-A rated, long duration securitized bonds, which offer an attractive spread relative to Treasuries and a defensive credit quality relative to the broader investment grade universe.
The second component of this strategy, which is the focus of today's call, is to recognize that ratings migration represents an opportunity for investors if they can broaden their portfolio strategy enough to take advantage. What we are advocating is the incorporation of a dedicated high yield exposure or possibly a broader multi-sector credit strategy to the traditional LDI portfolio.
This will allow pension to benefit from ratings migration by acquiring bonds that are downgraded after they have declined in price and selling them after they have returned to investment grade. These are the so-called fallen angels and rising stars. And this is the topic for my conversation today with Kay Herr and Lisa Coleman.
So as we begin this conversation, I thought I would start Lisa, with you and get into a little bit of the details about the market environment. So right now, we are anticipating quite a bit of activity and change in the environment. We're pivoting from the falling rate environment that we've been in for years, if not decades, to potentially one of rising rates.
There's volatility around inflation expectations and the Fed's policy reaction. We've got the economic reopening post COVID from vaccination and all of the things that that brings to the table. And obviously we're seeing continued global divergences, not just with respect to the COVID response but more broadly across economies. This is certainly a strong backdrop for active management. So take a moment and walk us through your perspective on where we stand today.
Lisa Coleman: Sure. Well, thanks for that question because I do think we really need to begin with a view from the top down. And Jared, you mentioned the Fed, and I think the Fed is going to be key to how investors should be positioning, certainly for the next 12 to 18 months.
So why are people so fixated on the Fed at the moment? Well, it's because we feel the Fed's going to be making a decision, most likely sometime this summer, most likely around the time of the Jackson Hole Symposium in August on what to do with monetary policy.
And we think that the first step for the Fed will begin to talk about the idea of tapering. And we believe that once that tapering talk comes out and a more formal policy is adopted late summer into September, we'll begin to see the Fed act in the first quarter of next year with beginning tapering and finishing up by the end of the year and that the first rate hike probably isn't going to happen until sometime late first or second quarter of 2023.
And so what is driving the Fed to make these policy adjustments? And I think there are two considerations here. The first is economic conditions, because clearly we're enjoying quite a robust rebound coming out of the pandemic.
And one thing that the Fed is looking for is job gains. And we're waiting to understand what the Fed defines as substantial progress. And we think that means a number of jobs continuing to come forward. That will be one signal that the Fed is comfortable to begin the tapering process. And we think we'll see that as we come through the next month or two.
The second is inflation. And as you mentioned in your opening remarks, inflation is getting a lot of attention. Now, we think the Fed is going to look through this as a transitory impact on prices, not necessarily a structural one, something that's occurring as a result of the bottlenecks when the economy reopens.
Now, it's not to say that we're going to not experience a very high print. I mean, we could see upwards of 3% on core inflation as we come through the next one to two quarters. But we think we're going to see that peak this year and come down to a more manageable level.
And again, inflation running a little bit more than that 2% that the Fed has often talked about is something that they said we're comfortable with an overshoot. So if we peak around 3% , come back down to a little above 2% for a while that, again would be a comfort level to the Fed.
So taking these different considerations into effect, we do think that this plan that we think will manifest itself starting sometime this summer is one that the market will have to come to terms with.
Now what does that mean for yields? As we said earlier, yields had bottomed in August. We were down near 50 basis points last year. And we've been trading in a pretty tight range now of 1.55% to 1-3/4%. We expect that as we get closer to year end we'll see 10-year yields rise up closer to 2%, again consistent with the expectations for the Fed to be on the move.
Now you also asked about recovery and COVID premiums is how I think about it. And let me just give you a couple of examples.
If we look at the investment grade market I feel pretty comfortable in telling you there is no COVID premium left. There might be a few idiosyncratic stories still out there. But if we look across broad sectors whether we're looking at financials and utilities and industrials, whether we look at spreads by ratings or maturities, they're all actually narrower than where we were pre-COVID. And in fact, we only have a handful of large issuers which have idiosyncratic stories that are still trading wider than where we were pre-COVID.
And then, of course, we have others that are actually significantly tighter than where we were pre-COVID. You know, companies that are in the midst of a more substantial deleveraging trend. So names like CDS or AbbVie, GE, et cetera, and even GM now trading tighter than where we were pre-COVID.
So it seems at least looking at the investment grade market and I think we could probably draw some similar analogies and high yield that those premiums have all but disappeared.
And then finally, looking geographically, I guess the only comment that I would have is from a valuation perspective, if we look at Europe, you know, Europe did not exhibit as much volatility as the US did, mainly because of the proactiveness of the ECB in terms of their bond buying programs, et cetera, for investment grade. That tend to keep spreads pretty much in check. And since that point US and Europe have been pretty much tracking each other and we can say the same thing for high yield.
Jared Gross: Great, thanks. The backdrop that you described which is rates currently in a stable range likely to go a bit higher as we experience some of this inflation which we expect to be transitory, coupled with credit valuations and spread levels that are fairly rich or at least sort of fully valued in terms of what we see in the market right now doesn't paint a particularly rosy picture for the returns across thea traditionally structured LDI program.
But again, most LDI investors recognize that what they're trying to do is hedge a liability that's going to move in the same direction and so maybe this is a good time to pivot to Kay and say, Kay, you know, as I've described, the concern that we have is not that the broad market movements will not be reflected in a similar fashion between and LDI portfolio and the liability that's hedging, but that the credit conditions may ultimately create some slippage there.
So talk to us about the health of the credit market and the quality of the IG universe as it stands today.
Kay Herr: Jared, I think those are actually two separate and distinct questions, so if you don't mind I'm going to separate them and address first the health of the investment grade universe.
So when we think about that health, both revenues and EBITDA are rising markedly. And indeed median leverage which I'll define as net debt to EBITDA for the investment grade universe that peaked at about 2-1/2 times last spring. And that's now down to about 2.1 times. And we expect companies to continue to delever organically in the strong economy.
And both you and Lisa have noted inflation. And I would concur that a bit of inflation can actually help, especially for companies that can pass through higher cost.
Then when we think about issuers and their ability to term out debt and to lower their overall borrowing costs Lisa touched on that a bit. I don't know if you wanted to elaborate Lisa?
Lisa Coleman: I think that's a really interesting point, because as I said earlier, we've seen interest rates and yields really bottom in the summer. So you would think, as we've seen yields rise, at least in the Treasury market, that borrowers would be experiencing higher costs.
But what's happened is we've had an offset in terms of credit spread compression that has managed to absorb much of that rise that we've seen in Treasury yields. And so for borrowers, it's actually still an incredibly attractive time to be issuing debt.
Also, you can consider what's rolling off in terms of maturing debt versus what the cost of new debt is. And the reduction is one of the highest that I think I've seen in many, many years. So it still is a very attractive time for borrowers to be tapping the market.
Kay Herr: And companies absolutely have the cash flow and the ability to support these leverage levels given the points that Lisa's made.
So turning to the second aspect of your question, Jared the quality, as you note in your paper, the overall credit quality of the investment grade universe has declined meaningfully. But I think it's important to reflect on why that's happened.
So I think very few companies now need a triple A or even a double credit rating. I think some notable exceptions to this are obviously financial companies, banks, also companies with large finance subsidiaries and then companies that are government contractors.
They arguably have a need for a high credit rating. So the rest of the corporate universe though I think the optimal rating is probably in the single A or the triple B type range.
I also think therefore that it's logical that given the increased number of triple B in double B issuers, as you highlight in your paper, both of those are at all time highs as you note, that migration between investment grade and high yield universes in the future is going to be greater than we've seen historically.
And as you noted, we saw record fallen angels in 2020 we're likely to have record rising stars in 2021 given the economic recovery that Lisa's touched on. But I think it's important to note that the rating agencies are lagging indicators.
So interestingly, downgrades by the rating agencies peaked last year in the second quarter which is actually when the economy and earnings troughed. So I think oftentimes the rating agencies are at best coincident or they can be very conservative in their nature and therefore somewhat lagging.
So we really need the research analysts to forecast future EBITDA, future leverage and to anticipate rising stars and fallen angels, not to wait for the agencies to confirm those. And I think Lisa would probably know that in many cases, the market prices, the anticipated upgrades and downgrades before the rating agencies actually act on them.
Jared Gross: Kay, thanks for that point and I think it's a good place to transition back to Lisa for some thoughts on how this works in practice for Lisa as a portfolio manager who's active in the credit markets. You have to balance the various information you get from the rating agencies, from the internal credit research that we do here at JPMorgan and how this dynamic movement across the investment grade, high yield barrier works in practice. So talk to us about fallen angels, rising stars, and as a PM how you put this into practice.
Lisa Coleman: Sure. So, you know, Kay right. I mean, the ratings agencies were really quite active last year. One might even call them a little feisty. You know, when we look at the first quarter just to put it in perspective, there was nearly a 120 billion of fallen angels in just the first quarter alone. And while the pace slowed as the year went on, I mean, they really tried to make their mark.
And frankly, when you look at the way spreads behaved, I think the market was quite fearful that more of the universe was going to get downgraded.
And so really the output of having good, solid credit analysis and what Kay and team did that was particularly helpful to us was going through different scenarios from an economic perspective and what that would mean for companies really helped us to hone in on identifying names that would be downgraded versus those that were likely to be retaining their investment grade rating.
But all that being said, we're in a very different time now nearly a year later. So in the first quarter of 2021 we've actually had zero fallen angels and in fact, about 14 billion of rising stars. So a complete turnaround in terms of ratings activity over the course of one year.
Now, it's interesting when you start to delve a little bit deeper into the composition of some of these companies that are moving back and forth between investment grade and high yield.
I mean, last year, one of the larger downgrades actually happened pre-COVID, and that was Kraft Heinz. And that was purely for idiosyncratic reasons that the company was downgraded.
Now, oddly enough, here is a company that had a tremendous benefit from COVID given the nature of its business. And in fact, that's a company now that we believe could see an upgrade back into the high quality universe again within the next 12 months. It's significant because it's a big borrower, roughly about $23 billion of value that can now move between these two universes.
Last year also saw Ford get downgraded which was of course a large component of the US investment grade market, was quite impactful to the high yield market. And that's one that while an upgrade is not really imminent, it's one that over time we could see Ford continuing to work their way back into the investment grade universe just as it did the last time for those people with a longer memory back in '05, when Ford was downgraded and eventually worked its way back up into the investment grade world again.
And then, of course, you've got names that are likely to be moving back up into the investment grade universe that were fallen angels from some time ago, a name like Freeport, major copper producer. Well, we all know what's going on with copper prices. I mean, Freeport is a very likely candidate for upgrade in the not too distant future. A company like CF Industries, which makes agricultural fertilizer, was downgraded several years ago, is also likely to move back up again.
And then a new entrant to the IG universe would be T-Mobile. So, again, there is a lot of movement between the two.
Now Kay raised a really interesting point because sometimes the market can be so anticipatory that it's almost anticlimactic when the bonds are actually upgraded into investment grade. Just to give you a couple of examples, you know, if we were to compare Netflix, which is likely to be moving into the investment grade universe, compare that to a similar company like Viacom, it's maybe only about 20, 25 basis points cheap at the moment. So the differential is not that great. A lot of that's been priced in.
Or if we look at a name like Kraft Heinz which I mentioned earlier, a good portion of that movement has already been captured by the market. Not to say there's not a little bit more spread compression to realize, but the bulk of that spread tightening has already occurred.
And then, you know, as I mentioned, Ford, the market is not pricing an imminent upgrade of Ford. if we look at the differential between a company like Ford and GM it's actually quite large so still time for that company, Ford, to work its way back up to investment grade metrics so could provide an opportunity still for somebody looking for a longer term play moving from high yield to investment grade.
Jared Gross: That's great, thanks Lisa. And I think what you've highlighted here is that this is not just a cover story about a wave of companies getting downgraded and now getting upgraded back on the recovery.
That to Kay's point we have a larger population of triple Bs. We have a larger population of double Bs. The idiosyncratic movement of individual companies across that line is likely to be elevated for the foreseeable future. And it's not just the story around the reopening of the crisis that we've been through.
And so the structural advantage of holding an active high yield portfolio is that it allows you over time to take advantage of that ratings migration much more fully than if the only way you express that is through active sales in a traditional IG portfolio where the best you can hope for is to be underweight those names that end up being downgraded. And it's very hard to anticipate the rising stars.
And so hopefully, you know, this has helped to kind of reinforce this notion that we began with, which is that the current position of most corporate pension funds towards their LDI portfolios is a much larger footprint within the asset allocation, a much more concentrated exposure to a relatively narrow piece of the credit markets, which is long duration IG corporate credit. And over time, as we experience this migration of credit across the IG high yield barrier they will face a headwind as a result. And it's good to be thoughtful about ways to approach that.
We spent a little time at the beginning on a more defensive idea around using securitized assets. But here today we really wanted to focus and drill down into this idea of active credit management and what it can bring not just within the space, but also moving more broadly into high yield.
And so maybe Lisa I'll just ask you in closing, it's not just a story of high yield. Obviously there's a sort of a multi-sector credit universe out there that has many of the beneficial characteristics of high yield. So just very quickly, walk us through what some of those other sectors are and how they helped to build a more resilient portfolio.
Lisa Coleman: Sure. So what we kind of strive for when we're thinking about a multi-sector credit portfolio is something that is structured to give you a good portion of the upside in terms of returns from high yield, because clearly over time they are quite attractive. But for those periods of time where you enter into severe volatility or a more meaningful economic downturn that can impact credit quality, you want a strategy that provides you more protection on the downside.
So, you know, what a multi-sector credit portfolio can do is give you a mix of different parts of the fixed income market that are designed to take advantage of different periods in the credit cycle.
One of the things that we like to use actively within our portfolios is obviously high yield, but also the opportunity to use loans. And when you think about the environment that we're expected to be in going forward with rising yields, loans provide a nice buffer against that rising yield environment and also give you a pretty attractive carry component.
A multi-sector portfolio could also include things like bank capital, deeply subordinated bank debt that gives you, I think, not only attractive carrier opportunities, but the opportunity to participate in European banks for example, where they have done a great job of building up their capital buffers and are expected to come through the pandemic very well particularly as European growth starts to take off and interest rates start to rise in Europe.
You might also use some EM corporates. And EM corporates are also experiencing that same improvement in credit quality that Kay highlighted earlier in the discussion. And then, of course IG. IG can still be part of a multi-sector portfolio, but it might not be used in the way that we traditionally think about IG with having a lot of duration to it.
What you might be doing is taking away some of that duration of the IG component and hedging that out and then trying to focus on idiosyncratic stories. There are lots of opportunities today so an IG from deleveraging that I alluded to and mentioned very quickly early on, I mentioned banks as well, and also some other idiosyncratic stories like the airline lessors that I think are an opportunity.
And then finally, convertible bonds, convertible bonds can provide you with a nice kick as equity markets do well in this environment. So a portfolio of these particular types of corporate securities can give you a nice risk in return profile. And then, of course, as you mentioned earlier, securitized is also another direction that one can look to as being suitable for the environment that we're in.
Jared Gross: That's terrific. And I think, again, in broad strokes what we're looking at here is an environment where the typical pension hedging portfolio with its concentration in corporate credit needs to diversify. The idea behind the securities is that you're staying up in quality and keeping a lot of those hedge characteristics. So it falls very squarely within the sort of high quality, long duration space.
But there's other directions in which diversification can matter, credit diversification as we've discussed today being a key one. And then, as you've highlighted there are segments of the fixed income markets that are broadly adjacent to the high yield and investment grade space where there's great opportunities right now.
And in an environment where rates may be rising and credit spreads may be widening, the power of that diversification to make portfolios more resilient is really critical and it can make a real difference in terms of performance across time.
So I think with that, we're going to wrap it up. I want to thank both of you, Lisa and Kay for joining us today. This has been a terrific discussion. And we welcome any questions or follow up from our clients who are listening. And please reach out to your JPMorgan advisors and we'll be happy to get in touch. So thank you very much.
Thank you for joining us today on JPMorgan Center for Investment Excellence. If you found our insights useful. You can find more episodes anywhere you listen to podcasts and on our Web site recorded on May 26, 2021.
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