For years, pension plan sponsors and fixed income managers have been concerned about the availability of investment grade corporate bonds. Corporations are presumed to be less likely to issue debt in the future given the new corporate tax law. Pension plans, who like to use corporate bonds to hedge liabilities, are becoming better funded with positive market returns and hefty contributions which reduce PBGC premiums and maximize deductions before tax rules change. Better funding leads investors to shift asset allocations toward fixed income, which in turn presumably will significantly increase demand for corporate bonds, especially as plans close or freeze. What’s a pension investor to do?
Liabilities and corporate bond supply
Pension plan liabilities are calculated using yield curves built from baskets of high quality corporate bonds. Naturally, therefore, the liability’s value moves like corporate bonds with changes in treasury rates and credit spreads. Liabilities increase if either treasury rates fall or credit spreads narrow; conversely, liabilities decrease if either treasury rates rise or credit spreads widen. So, it seems sensible that corporate bonds would nicely hedge liabilities, and, in fact, they mostly do when evaluating bonds in isolation against the liabilities.
If supply of corporate bonds diminishes for any reason, like less incentive to issue debt because of new tax laws, and if demand for the corporate bonds that exist now increases because pension plans become better funded, then you can see why a pension plan sponsor or a long credit or long corporate investment manager would begin to worry. Buying corporate bonds later, when yields are compressed because buyers are compelled to pay more and more in a crowded market on a limited supply, could be expensive and time consuming. It even seems like it might be prudent to start building the bond portfolio sooner rather than later if you think buying corporate bonds might get harder in the future.
Offsetting liability spreads is messy
Liability returns are determined by treasury rate and spread changes. Given that treasury bond issuance is one and a half times that of investment grade corporate bonds1 and that average daily trading volume of treasuries is more than 15 times corporate debt2, perhaps they can be used to offset the supply problem. Treasury bonds have no credit spread exposure but can be used to hedge the treasury rate movement of liabilities extremely well. But, what about spreads?
Spreads create a several problems. One is that liability spreads are based on a basket of bonds that have different cash flows than the liabilities and from each other. Some bonds will have more influence on one rate along the curve than another. In any event, it is completely impossible to invest in a set of bonds that will match the cash flows and yields on which liabilities are based. Another is that those baskets of bonds change from period to period based on ratings and which subset of bonds within that rating are chosen. In the case of downgrades and defaults, the liabilities don’t lose value, because those bonds simply fall out of the basket of bonds used for the yield calculations. But if you have those bonds in your asset portfolio, your assets surely do lose value. This creates a problem where it’s impossible to maintain a set of bonds that keeps up with the liability return at the same risk level.
So now we’re left with a problem where treasuries do an excellent job of offsetting the treasury rate exposure, but completely miss on the credit spread exposure. Complicating matters further, we need to be concerned that credit spread exposure can’t be offset well, even with corporate bonds, because no matter what you do there will be a huge amount of basis risk when it comes to credit spreads. Either way you might find it hard to keep up with liability returns over a long horizon.
Luckily, we’ve advanced to the point where we can evaluate the liabilities against the total asset portfolio, including return seeking assets, rather than just a single sleeve. After all, our overall goal is to achieve the right balance of risk and reward for the total portfolio, not simply within the bond portfolio.
Along those lines, let’s consider equities. Looking back at historical spread returns on long corporate bonds, an interesting pattern emerges. If the credit spreads narrow dramatically, equity returns are typically very large. Conversely, when spreads blow out you will often see large negative returns on equity.
In a total plan context, this is important. Corporate bonds seem a good fit because the spread return of the bonds and liability are related (interest rate exposure can be taken care of with just treasuries). On a total plan basis, other assets have returns related to the spread return, too.
If liabilities increase because spreads narrow, we want our assets to rise enough to offset that. Historically, it hasn’t taken very much equity to offset the liability growth from narrowing spreads. No additional credit spread exposure from corporate bonds was needed to keep up. Going the other direction, as spreads have widened and liabilities decreased, equities have often fallen even further. That is harmful to the plan’s funded status, but that problem is only exacerbated by also having credit exposure in bonds.
The point here is that from a total plan perspective, perhaps we need not worry so much about a diminishing supply of credit after all. Rather, we can get spread exposure in ways we hadn’t considered, including the equity or other return seeking assets that may already be in the portfolio. Regarding the liabilities, why not use treasuries to hedge what you can and then pick the best portfolio of return-seeking assets to cover what you can’t, while balancing both in terms of total plan outcomes?
1 Treasury Notes and Bonds issuance in 2017, 2016 and 2015 was $1.914 trillion, $1.854 trillion, and $1.803 trillion, respectively, while Investment Grade Corporate Bond issuance was $1.318 trillion, $1.279 trillion, and 1.216 trillion. Source: SIFMA, data as of the end of December 2017.
2 Average Daily Volume of Treasuries was $504.8 billion, of Corporate Debt was $30.7 billion. Source: SIFMA; data as of end of December 2017.