Pension and insurance strategies: when traditional measures fail to capture the risk for income focused portfolios
Wei Chu CFA
Pension and Insurance clients may look to total return or income focused strategies to meet their investment objectives. In assessing both type of strategies, it is important to understand traditional metrics of risk may not be appropriate for income focused strategies.
The investment approach of total return strategies focus primarily on top-down investment views (asset allocation, duration, curve) followed by bottom-up analysis (sector, issuer, security); while income focused strategies focus on bottom-up analysis, namely the fundamental strength of each individual company. Traditional measures of risk management include Tracking Error (TE) and Value at Risk (VaR) both consider the deviation of returns of a total return strategy versus those of the benchmark. It’s plain to see that these traditional measures are unsuited to a benchmark agnostic income focused approach where the emphasis is on ratings stability.
For Income focused portfolios, a rigorous assessment of the fundamentals is important to ensure the long standing quality of these portfolios. A low level of turnover is borne out of the buy and sell discipline which is clearly articulated for income focused strategies. The manager carefully considers the analyst’s fundamental credit opinion on whether a sale is required (or a purchase should be made). The decision is driven by the level of visibility the analyst has on the future cashflow predictability of the bond and its ability to meet liability cashflows. Unlike total return strategies, income focused strategies must consider the importance of investment income, realizing gains and losses as well as reinvestment risk. Insurance clients specifically will also have accounting considerations such as IFRS9 which introduced the concept of expected credit losses (ECL). IFRS9 is an impairment model based on the deterioration of underlying credit quality of an issuer, and can lead to great earnings volatility for an insurance company.
Income focused strategies exhibit less turnover but are also deemed benchmark agnostic with the objectives more closely aligned to client specific cashflows or liabilities. Initial portfolio construction, selecting the appropriate assets to meet these cashflows, is a crucial stage of the income focused investment process. Once the assets and liabilities are aligned, maintenance of these assets is key to ensure the scheduled cashflows are met. It is for this reason, risk management should focus on fundamental credit quality and ratings stability when assessing the risks inherent in the strategy.
Analysis of ratings evolution and complementary metrics
When the current economic expansion nears its end, the credit quality of our income focused strategies will be tested. As part of our risk management around these strategies we look to the evolution of ratings migration during previous downturns to determine how strategies will be impacted at the end of the cycle. In a recent blog, we assessed how a future economic downturn would compare to previous downturns using National Bureau of Economic Research defined recessions from 1981 to 2009. We concluded the next recession would be most analogous to the one which occurred in 2001, which was the longest period of growth in U.S. history up to that point. Despite the bursting of the ‘dot-com bubble’, GDP declined by just 0.3% from peak to trough and unemployment increased to 6.3%. Based on ratings migration over the following two years, this scenario assumes that 15% of A rated companies will be downgraded to BBB or below, while 17% of BBB rated companies will be downgraded to below investment grade.
It is important to understand the spread impact due to rating migration as our risk management team will assign a spread move per rating bracket to determine the overall portfolio impact. The spread widening is tiered by bucket and our broad based assumption is that A rated spreads would widen 30% on a downgrade to BBB while BBB rated spreads would widen 70% on a downgrade to high yield (<BBB).
As described above, the main characteristic of an income focused strategy is the maintenance of credit quality, which ultimately leads to ratings stability and low turnover. We look to restrict turnover to approximately 5%; this is a function of diversification into new issuers, credit migration through the cycle and/or a change in client guidelines or assumptions. Turnover may in fact fluctuate somewhat at different stages of the credit cycle. The global economy is currently experiencing its longest economic expansion and credit conditions are favorable leading to upward ratings migration and low defaults. However, we believe we are now nearing the end of this cycle and expect ratings migration to deteriorate going forward. As such, we will continue to monitor the implicit correlation of credits in the portfolio in order to assess to what degree the portfolio is diversified.
How to measure performance?
The upgrade/downgrade ratio is a key metric to measure the ratings migration of the portfolio over time. Investors incorporate the impact of expected ratings migration into the returns they expect to achieve from the strategy.
Book yield attribution is a key metric to consider since income focused strategies’ main objective is to generate sustainable income. As yield levels develop over time and bonds mature, it is important to monitor the evolution of portfolio income as well as the risk taken to achieve it. Book yield may be gained through purchases and lost through sales and maturities.
An income focused strategy is designed to have low turnover as described above. A low turnover strategy is achieved through rigorous initial portfolio construction. Turnover statistics are arguably an additional factor to consider when assessing the performance of income focused strategies since traditional measure of performance versus benchmarks fail to consider turnover levels.