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Liability-Driven Investing (LDI): Finding a Shorter, Different Path
Fixed Income

Liability-Driven Investing (LDI): Finding a Shorter, Different PathLiability-DrivenInvesting(LDI):FindingaShorter,DifferentPath

Dec 10, 2024

5 mins

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The rise in corporate bond yields over the past few years caused several chain reactions affecting corporate defined benefit plans:

  • The average plans’ duration has decreased.
  • The average funded status has vastly improved (helped by strong equity returns), racing through glidepath triggers and requiring increased fixed income allocations.
  • Higher fixed income allocations are now driving two asset allocation decisions within fixed income:
    1. The desire for alternatives to corporate credit - the top 10 issuers in the Bloomberg US Long Corporate and Long Credit Bond Indices represent ~15% of each Index.
    2. A need to focus on hedging intermediate duration liabilities to mitigate curve risk.

We believe plan sponsors can address these needs with an allocation to an Intermediate Aggregate strategy - the plan receives exposure to a broader opportunity set with diversification from the high-quality securitized space.

Is it time to consider a shorter path?

  • Plans often calculate the present value of their liabilities using discount rates based on high quality, mostly AA-rated corporate bonds. To reduce funded status volatility, many plans invest substantial portions of plan assets in long corporate bonds.
  • However, corporate pensions’ fixed income duration needs have been trending down. With most plans soft or hard frozen, liability durations will continue to decrease as plans age.
  • Recent higher funded statuses and increased allocations to fixed income have also resulted in reduced duration requirements to maintain target hedge ratios, which now makes an intermediate allocation more attractive.
  • An intermediate allocation can also help reduce curve risk without getting as precise as duration/cash flow matching or pure immunization.

Adding an Intermediate Duration Index can help meet hedge ratios, while also providing broader curve exposure and improving the hedge with liabilities.

What path to take in the intermediate space?

  • For most plans, the return-seeking component continues to be higher beta versus the liability return, usually coming in the form of equities or, in fixed income, lower-rated and/or illiquid credit.
  • In our view, higher beta fixed income has disadvantages during periods of volatility as this allocation can reduce liquidity and cause higher negative skew versus liabilities.
  • A pure Credit Index does not help mitigate these risks, and many plans already have large allocations to corporate credit. However, the securitized market offers a high quality, liquid, diversified, and lower volatility alternative to corporate credit in the intermediate part of the curve.

An alternative to Intermediate Credit is allocating to the Bloomberg US Intermediate Aggregate Bond Index where securitized comprises ~34% of the underlying Index.

How to navigate the securitized market along an LDI journey?

We define high quality securitized primarily as Agency MBS, AAA CMBS, and AAA Consumer ABS.

  • Agency MBS is a large market (~9.3bn in market value^), offers good liquidity (especially in the TBA market), has an implicit/explicit government guarantee, and delivers diversification versus corporate credit.
  • AAA CMBS and AAA Consumer ABS offer very good liquidity and structural protections that can reduce both correlation and downside versus corporate credit.
  • Plan sponsors may consider limiting exposure to Non-Agency RMBS and Agency CMOs, due to weaker liquidity, as well as avoiding CLOs, Aircraft ABS, and other non-AAA securitized sectors, due to little diversification benefit versus corporate credit.

Our analysis of high quality securitized has shown the following:

  1. Securitized tends to widen with corporate credit during liquidity crises, but not when widening is credit specific (Exhibit 1).
  2. Securitized shows a low correlation of excess returns to other spread sectors and very low correlation to equities (Exhibit 2).
  3. Securitized has outperformed U.S. Treasuries and the risk-adjusted returns are attractive compared to high quality corporate credit (Exhibit 3).

We believe by incorporating high quality securitized assets into an LDI asset allocation strategy a plan can achieve diversification, increase liquidity, and reduce funded status volatility (particularly on the downside).

Where is the bump in the road?

 

One of the main reasons LDI investors have shied away from securitized in an LDI framework is the negative convexity of Agency MBS, which results in fluctuating durations.

  • Agency MBS’ price/rate relationship is negatively convex, due to the likelihood the homeowner will refinance into a lower-rate mortgage when yields fall, and conversely, the homeowner’s tendency to remain in the mortgage when yields rise. As a result of prepayments, the expected maturity (duration) of the security shortens, as principal is returned sooner, and the investor will be faced with reinvesting at lower rates. When rates increase and prepayments slow, the duration extends.

These risks can be managed through active portfolio management that utilizes sector rotation, security selection, portfolio hedges, and duration management.

  • For example, we evaluate changing Agency MBS durations in determining relative value and hedging. We keep the total portfolio duration neutral to the benchmark, and we utilize ten key-rates (1yr, 2yr, 3yr, 5yr, 7yr, 10yr, 15yr, 20yr, 25yr, and 30yr) to hedge our Agency MBS exposure versus the market practice of only using the 10yr key-rate.

 

Does a shorter, different path fit your plans’ objectives?

  • We believe active investors in the securitized market, specifically in Agency MBS, have significant opportunities to generate alpha from sector rotation, security selection, and duration management.
  • Historically, the risk-adjusted returns of the Securitized and Intermediate Aggregate Indices have offered a competitive alternative to corporate credit indices with a lower volatility profile.
  • By allocating to an Intermediate Aggregate strategy, a plan gets additional diversification (via its securitized exposure) versus corporate credit and a low correlation to equities, especially during times of market stress.
  • At Jennison, we have more than 40 years of experience partnering with our pension clients in crafting custom LDI solutions. We can help clients navigate the unique risks and opportunities of the market to determine if an Intermediate Aggregate strategy can help meet your plans’ objectives.
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End Notes

Sources:

Jennison Associates LLC Moody’s Investor Services, Inc. eVestment

^“Bloomberg®” and Bloomberg Indices are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Jennison Associates LLC (“Jennison”).

Bloomberg is not affiliated with Jennison, and Bloomberg does not approve, endorse, review, or recommend Jennison's products. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to Jennison's products.

S&P. Copyright 2024, Standard & Poor's, a division of The McGraw-Hill Companies, Inc. Standard & Poor's including its subsidiary corporations ("S&P") is a division of The McGraw-Hill Companies, Inc. S&P and/or its third party licensors have exclusive proprietary rights in S&P data. S&P data may only be used internally for business purposes and shall not be used for any unlawful or unauthorized purposes. Dissemination, distribution or reproduction of S&P data in any form is strictly prohibited except with the prior written permission of S&P. S&P does not guarantee the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information.

All data provided is as of 9/30/2024.

There is no guarantee our objectives will be met. All investments contain risk, including possible loss of principal. The strategy may vary significantly from the benchmark in several ways including, but not limited to, sector and issuer weightings, portfolio characteristics, and security types. Diversification does not protect an investor from market risk and does not ensure a profit or guarantee against a loss.

For informational purposes only and not for redistribution. This information is not intended as investment advice and is not a recommendation about managing or investing assets. Jennison makes no representations regarding the suitability of any securities, financial instruments or strategies described herein. In providing this information, Jennison is not acting as your fiduciary. This information does not purport to provide any legal, tax or accounting advice.

The information contained in this document is directed only to qualified professionals and eligible institutional investors. Distribution of this information to any person other than the person to whom this presentation has been originally delivered, and to such person's advisers, is not permitted. Any reproduction of these materials, in whole or in part, or the disclosure or redistribution of any of its contents, without the prior written consent of Jennison, is prohibited. These materials may contain confidential information and the recipient thereof agrees to maintain the confidentiality of such information.

Forecasts may not be achieved and are not a guarantee or reliable indicator of future results.

The views expressed herein are those of Jennison Associates LLC investment professionals at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice.

Certain third party information in this document has been obtained from sources that Jennison believes to be reliable as of the date presented; however, Jennison cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as reference herein) and is subject to change without notice. Jennison has no obligation to update any or all such third party information; nor do we make any express or implied warranties or representations as to the completeness or accuracy of the third party information.

 

Jennison Associates is a registered investment advisor under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level of skill or training. Jennison Associates LLC has not been licensed or registered to provide investment services in any jurisdiction outside the United States. Additionally, vehicles may not be registered or available for investment in all jurisdictions. Prudential Financial, Inc. of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom.

 

Please visit https://www.jennison.com/important-disclosures for important information, including information on non-US jurisdictions

Market Definitions:

Beta – a measure of the volatility of a security or portfolio compared to the market as a whole.

Duration - a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. Excess Return - is the additional return generated by the portfolio or composite relative to its benchmark.

Maturity – the date on which the life of a transaction or financial instrument ends, after which it must either be renewed or it will cease to exist. The term is most commonly used in relation to bonds but is also used for deposits, currencies, interest rate and commodity swaps, options, loans, and other transactions.

Option Adjusted Spread (OAS) - the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.

Sharpe Ratio – a measure of an investment’s risk-adjusted performance, calculated by comparing its return to that of a risk-free asset.

Standard Deviation – a statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance. Yield – a general term that relates to the return on the capital you invest in a bond.

Yield to Worst (YTW) – a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting.

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