Interest rates have dropped dramatically and credit spreads have widened to rarely seen levels as COVID-19 has spread across the globe. The moves in interest rates and credit spreads have fundamentally changed the distribution of potential outcomes (Exhibit 1), with downside potential in rates bounded near zero and potential for downside performance in credit spreads bounded by their current elevated levels and Federal Reserve asset purchases. As a result, pension plans are reconsidering asset allocations to better hedge their liabilities in this new regime and take advantage of market opportunities as they arise. While individual circumstances vary, we believe that plans may want to consider increasing the amount of corporate credit in their hedging portfolios, particularly in the 1-10 year maturities that have been hit the hardest and, among our clients, we have seen plans moving in this direction.
Source: GSAM. For illustrative purposes only.
Equity markets remain volatile, credit spreads have widened materially from their early 2020 tights, and longer- dated interest rates have fallen to unprecedented levels. At GSAM we believe that plan sponsors may want to approach this constantly changing environment by asking themselves: (i) What opportunities does this create?; (ii) What assumptions or rules of thumb are called into question by the new environment; and (iii) How should our long-term strategy respond, in particular with respect to a liability driven investment (LDI) program?
In our view, in the current environment corporate credit is generally the most attractive opportunity in fixed income markets from a risk/return perspective. These markets were badly damaged by the lack of available liquidity in mid-March, which has created an opportunity to buy credit at potentially attractive levels (see GSAM’s publication, “Corporate Credit: The Time Is Now”). This is especially true for shorter-maturity bonds whose credit spreads had widened the most. Plans that are relatively well funded may view this as an attractive time to add corporate credit exposure and capture the potential for above-average returns.
In terms of heuristics and long held rules of thumb being called into question, the current environment has challenged standard relative value relationships. Among the relationships being called into question are the relative risk of interest rate volatility and credit spread volatility as well as the relative emphasis that should be placed on each of those risk factors in a liability hedging program. When long duration investment grade credit spreads are in the mid-200s and 10-year Treasury yields are hovering around 50 basis points, the relative importance of hedging credit risk in an LDI portfolio has clearly increased.
The current levels of risk-free rates will also likely impact long-held assumptions on the volatility of longer-term risk-free rates and the likely direction of future moves in these rates as Treasury yields reach or go below zero. The answers to these questions, as well as the plusses and minuses of owning more or less interest rate and/or corporate credit exposure, could have a material impact on investment strategy.
Clients have been keenly focused on market movements, particularly the relative performance of the different sectors held across their broader asset allocations. Many of our pension plan clients responded, or are responding, to these market movements by adding additional corporate credit exposure. As a reminder, US corporate pension plans value their liabilities for financial reporting purposes based on the yields of high-quality, corporate bonds. In other words, the discount rate has a credit component to it.
Clients have chosen a variety of ways to implement these changes, including benchmark revisions (e.g., moving from government credit benchmarks to 100% credit benchmarks) or adding new credit sleeves benchmarked to intermediate (1-10Y) credit indices. A minority of our clients have reduced, or deferred, planned increases in their interest rate hedges. For plans that manage their hedging portfolios against a custom, liability-driven benchmark, GSAM has worked with these clients to optimize capital allocations within their hedging portfolios, often resulting in an increase in their hedging program’s overall level of corporate credit exposure.
Most clients that have been adding credit have been doing so for strategic reasons, with the timing of the move motivated by recent market events. Those that have added intermediate credit exposure have taken advantage of the credit curve flattening, and even becoming briefly inverted, as short- and intermediate-maturity credits traded wider than long-maturity credits. For clients already seeking to improve the strategic balance between their long-maturity credit bonds and intermediate-maturity holdings, this curve flattening has created an attractive relative value opportunity.
Clients that have reduced, or deferred, planned increases in their interest rate hedges have been motivated by short-term tactical and opportunistic considerations. When taking such active views in their fixed income hedging portfolios, we educate our clients on sizing the risk of the active view—e.g., consider sizing the deviation in duration exposure to be in line with the duration deviation limit that would ordinarily be given to a third-party active manager having an equivalent-sized portfolio. The intention is to seek a balance of active risk-taking in the portfolio, so that no one active view is dominating the investment outcome. The hedging portfolio is often so large, and sometimes augmented with leverage, that what seems like a modest shift in positioning can still be a very large active risk in comparison with other active managers in the portfolio.
It’s also important to note that while the level of interest rates is low, interest rate volatility has not declined by a proportionate amount. For example, in the mid-1990s, US 10-year Treasury yields were around 6% and today they are well inside of 1%. Yield volatility was 90 to 100 basis points (annualized) in the mid-1990s, and is around 70 basis points (annualized) today. A ten-fold reduction in yield levels was accompanied by a reduction in yield volatility of only around one-quarter. Also, while US rates have declined to unprecedented levels, rate regimes in non-US markets are lower still, with 10 year UK gilt yields approaching 25 basis points and 10 year German bund yields near negative 50 basis points.
We do not expect longer maturity US Treasury yields to fall to negative territory, but should this occur the trade-off in such an environment between reducing rate-related risk and the cost to do so may lead to changes in our views on corporate credit allocations. In a negative rate regime, US pension plans may wish to consider transitioning from a strong focus on interest rate risk management to one increasingly focused on credit spread risk management.