Construction Ahead: Putting Together the LDI Portfolio May Become More Challenging. While many corporate DB plan sponsors will continue to focus on building out their fixed income portfolio and increasing their plan’s hedge ratio, actually putting together that portfolio may become more challenging going forward. We cite several reasons why this may be the case:
- Potentially lower investment grade corporate bond supply, in particular at the long end, after a multi-year period of robust issuance,
- Supply that is not well diversified through the economy, leading to industry concentration,
- A greater percentage of investment grade bonds rated BBB than in the past, meaning sponsors may need to hold a lower quality portfolio than they may have had to previously, and
- We're likely closer to the end of the credit cycle than the beginning, potentially contributing to increased downgrade activity.
This all suggests a more challenging environment to construct an LDI portfolio and highlights the potential benefits of engaging an active LDI manager with experience in constructing appropriate portfolios. It may also lead some sponsors to contemplate other asset classes outside of corporate credit that may be utilized as part of a liability hedging program.
The Next Wave of Risk Transfer: Full Plan Termination? As highlighted earlier, the trend of risk transfer continues, with more plans coming back to market to do multiple deals. While many sponsors have, in the past, focused solely on retired participants for these transactions as this cohort tends to command the smallest amount of premium from an insurer, we see evidence that sponsors (and insurers) may be more willing to explore transactions that involve active and terminated vested (TVs) participants. Participants involved in Bristol-Myers’ recently announced multi-billion dollar full plan termination were predominately actives and TVs, which is not surprising given the company is another example of an organization that had completed a previous annuitization in 2014, which involved solely retirees, and has now come back to market again. Transactions that expand out to include more actives and TVs may be the next wave, whether it involves a full plan termination or not.
De-Risking More Than Just Bonds: Considerations for the Return Generating Portfolio. Many plans have put in place the strategy for the fixed income side of their de-risking program, and are set to execute on it over the next several years. But as these programs become more developed, sponsors are starting to focus on what the return generating side of their portfolio should look like. This has been further spurred by the recent market volatility and has contributed to increased interest in strategies such as defensive equity, low volatility equity, alternative risk premia, and hedge fund replication. We have also seen more sponsors consider the use of derivative overlays for the hedging portfolio, which allows more capital to be allocated to the return generating portfolio, potentially increasing returns at a similar level of risk. We suspect more sponsors will take a closer look at this side of their de-risking programs in 2019.
Out the Door: Managing Liquidity Increasingly Important as More Plans Cash Flow Negative/Cash Becomes a Strategic Asset Again. Even with notable contribution activity, most corporate DB plans are cash flow negative as they pay out more in benefit payments than they receive in from their sponsors. This is a dynamic that will likely continue in future years as more plans mature. This could argue for sponsors to hold more cash in order to fund outflows and avoid liquidating other components of the portfolio, in particular during what may be deemed to be inopportune times. In addition, holding more cash or short term investments may become more palpable for sponsors as yields rise and as cash potentially becomes a strategic asset class again with an associated return component.