LDI Portfolio Construction May Get Trickier in 2019

As funds lock in 2018 gains, high-quality fixed income could become harder to find, Goldman Sachs exec says.

While many defined benefit plan sponsors look to enhance their fixed-income portfolio and increase their plan’s hedge ratio, they may find constructing liability-driven investment (LDI) strategies more difficult in 2019, according to Mike Moran, senior pension strategist at Goldman Sachs Asset Management.

According to Moran, several factors will likely contribute to making LDI portfolio construction more difficult.  These include a potentially lower investment-grade corporate bond supply; supply that is not well diversified through the economy, leading to industry concentration; and a higher percentage of lower-rated investment-grade bonds than in the past. 

In an interview with CIO, Moran explained that because many corporate defined benefit pension plans saw their funded status rise during 2018, many of them have likely already shifted their asset allocations to fixed income to help lock in these gains—a trend that could lead to a run on high-quality fixed-income investments.

He also said that the economy is likely closer to the end of the credit cycle than the beginning, which could lead to increased downgrade activity.

“It just argues for a much more difficult environment to put together an LDI portfolio,” said Moran. “You have to not only match the liabilities well, you have to make sure you’re actively managing that portfolio to avoid and manage downgrades, and also find a portfolio that is properly diversified in an environment where we may not have as many corporate credit issues as we’ve had in the past.”

Moran says that as the environment makes it more difficult to create an LDI portfolio, it increases the importance of picking an LDI manager with a lot of experience. He also says this is no time to have a passive LDI portfolio.

“In an environment where we’re probably closer to the end of the credit cycle where there’s more BBBs in the investment grade market than there were 10 years ago, it implies that you want an active pair of hands on managing that portfolio,” said Moran.

Moran also said with volatility making a comeback after a long stretch where investors enjoyed relatively calm markets until last year, the work for plan sponsors will become more difficult. However, he said there are some strategies corporate defined benefit plans could deploy in 2019 to help prepare for increased volatility.

He said that because liabilities are bond-like in nature in that they rise and fall as interest rates rise and fall, the best way to minimize the volatility of the liabilities is by having assets that match them in terms of rising and falling, such as long-duration fixed income.

“The volatility tool of choice for many plans has been and continues to be to increase allocations to long-duration fixed income as an asset-liability matching exercise,” he said. “That way as interest rates go up and down, their assets and liabilities go up and down in tandem, reducing that volatility. Also, by moving to more fixed income, you’re reducing the equity exposure in the plan so you’re reducing the amount of equity volatility you face.”

He also said that some plans could utilize derivatives as a way to fine tune that hedge. Moran said he has 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, thus potentially increasing returns that are at a similar level of risk. He said he expects more plan sponsors will take a closer look at this side of their de-risking programs in 2019.

“It’s not as simple as thinking that if my liabilities have a duration of 12 years I’m going to have fixed-income assets that have a duration of 12 years and therefore I’m fully hedged,” Moran said, “because you can over hedge or under hedge on different points on the curve.”

He also said that on the return-generating side, “good old-fashioned diversification” can also help reduce volatility. He suggested diversifying into other asset classes such as non-core fixed income, alternative risk premia, hedge fund or hedge fund replication strategies, low-volatility equity strategies, and hedged equity strategies.

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