MASTERCLASS: Fixed Income & LDI - October 2020

The Coronavirus pandemic and the Fed’s dramatic rate cuts have shaken up the fixed income landscape. This panel discussion covers diversification techniques, liability benchmarking, ways to manage risk, and other important considerations in this low yield environment.

  • James DiChiaro, Senior Portfolio Manager, Insight Investment, a BNY Mellon Company
  • Tom McCartan, FIA, CFA, Principal of Liability-Driven Investment Strategies , PGIM Fixed Income
  • Oleg Gershkovich, A.S.A., M.A.A.A., LDI Solutions Strategist, Fixed Income, Voya Investment Management

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  • 01 hr 04 mins 06 secs

Jenna Dagenhart: Hello and welcome to Asset TV's LDI Masterclass. The coronavirus pandemic and the Fed's dramatic rate cuts have shaken up the fixed income landscape. Today, we'll cover diversification techniques, liability benchmarking, ways to manage risk, and other important considerations in this low-yield environment. Joining us now, our three expert panelists. Tom McCartan, Principal of Liability-Driven Investment Strategies at PGIM Fixed Income, Oleg Gershkovich, LDI Strategist and Senior Actuary at Voya Investment Management, and James DiChiaro, Senior Portfolio Manager at Insight Investment. Everyone, thank you for joining us. I want to start with COVID-19 and the current market environment. Oleg, how has the coronavirus pandemic impacted the pension industry?

Oleg Gershkovich: Hi, Jenna. Yeah, that's a great question and very topical these days. Everybody's looking at what happened over Q1, and since then, I'm trying to put together a story over what happened to the pension industry overall. And I think COVID-19 definitely exposed many pension plans that were under-hedged, while those that were well-funded and highly hedged weathered the storm far better than the rest. Sometimes, I like to look at this with context to the draw down that happened during the Great Financial Crisis.

Oleg Gershkovich: During that time, the draw down was almost 50%. So while this COVID Q1 2020 draw down wasn't that deep, it's still kind of interesting to compare to that time, because back then, only 5% of the pension plans had an allocation of fixed income that was greater than 50%, whereas this time, many of the plan sponsors, more than half now have, or almost half have allocation of fixed income of over 50%. And I think what that did was its kind of muted the impact of the coronavirus hit, so I'd say pension plans did as a whole better during Q1 2020 than they would have had if they had the same 30/70, 30% fixed income allocation that they had at 12/31/2007. Whereas instead, now they're at 50% fixed income, or they were at least at 12/31/2019.

Oleg Gershkovich: So, the drop would have been 9 to 12%, but instead, it was maybe on average 8 to 9%. And again, different plans weathered that storm differently.

Jenna Dagenhart: Tom, what would you say has changed the most in 2020?

Tom McCartan: It’s almost easier to answer that as ‘what hasn’t changed this year?” and it feels like almost every aspect of every day life has whether it comes to working, education, to travel, how we socialize to huge changes in what is acceptable in monetary policy, and fiscal policy. I think that when you think about everything that’s changed this year, what really stands out to me, as potentially the biggest change that could have the biggest long-term effects, is this almost overnight acceptance of this monetary theory by countries policy makers all around the world. It seems that deficits don’t matter anymore; we’re just going to have central banks buy all the debt and monetize the debt. And if I told you a few years ago that a Republican executive would buy 15 or 16 percent in spending driven fiscal deficit, you’d probably laugh at me and call me crazy. So, things have really changed dramatically in that sense. And I think it’s difficult even now to really understand just how profound and deep the lasting impacts of that are going to be on economics, on investing, on market returns for years, if not decades, to come.  

Jenna Dagenhart: Yeah, I think that's a better way of looking at it. What hasn't changed in 2020? And James, at this point, do you think underlying volatility has been baked in or could we see some adjustments?

James DiChiaro: Thanks for having me on your show, Jenna. Volatility's an interesting question. I mean, short answer is yes, I do think there is quite a bit of volatility baked into the market right now, but it's also important to note that it has come off of highs. Volatility as indicated by the VIX was I want to say in the 80s back in the second quarter of this year, where it still stuck in the 20 to 30 range. Now that's still an elevated level, but you can argue there's actually a pretty good reason for it. We still have quite a bit of uncertainty surrounding the COVID-19 virus, and how long the impacts of this virus will be felt. And secondly, we have the upcoming presidential election, which has left a really interesting mark on the market. It seems that just about every presidential scenario has been priced into the market outside of having a next day winner. So, it seems like we're expecting that we're going to have a ton of volatility leading up to the election.

James DiChiaro: We're going to have uncertainty as to who is the president for a number of days, if not weeks following the election. So, the point that I would make is that the one thing that's not priced in is that a guy like Joe Biden holds his lead and it's really just a straight line and he's announced the winner the following day. At which point I think with each passing day, credit spreads and perhaps equity to some degree should move a little bit tighter and a little bit higher in valuation.

Jenna Dagenhart: So you're saying more or less, everything has been priced in except for the expected?

James DiChiaro: For what is more likely, yes. In my opinion.

Jenna Dagenhart: And Oleg, how has COVID-19 shifted investments?

Oleg Gershkovich: I think for pension plans, there was definitely this gradual or maybe sudden overweight to fixed income as equities kind of deteriorated. But then as the Fed came in and provided the liquidity that was much needed, basically and starting in Q2, the investors generally rebalanced back to their targets. Generally, I say. I think there's definitely some pension sponsors that decided to take some risks and time that market, and I'd say that that's something that is a tricky endeavor. History shows that it's not usually a successful one. So, I'd say that it's really important to not lose sight of the bigger picture objectives.

Oleg Gershkovich: I'd say that there's broadly two types of pension plan sponsors or pension investors, and there are those that are continuing to de-risk. So, they saw that shift and they want to hold the line. They want to de-risk, they're not going to try to time things and they're on a steady path with contributions, fixed income allocations, high head ratios and so they're going to continue that path. And maybe those plans are typically 90% funded or better. And then there's kind of broadly speaking, the other side, where maybe they're not as well-funded, and so they're going to try to get those equity returns.

Oleg Gershkovich: And I'd say for that latter group, consider using derivatives if they haven't done so already to get that interest rate hedging. Exposure, because you don't want to get exposed. I know rates are still 70 basis points lower as of recently. August 31, let's say. And maybe even at the end of today. It's pretty flat over the month of September, but the equities may have come back a bit and maybe there was some timing happening out there, and the investments definitely did shift. The liabilities are still higher than they were at the end of the prior year.

Jenna Dagenhart: And Tom, is there still relative value in the credit markets?

Tom McCartan: [inaudible 00:08:18] and the [inaudible 00:09:13]. However, [inaudible 00:09:18].

Jenna Dagenhart: And sticking with the credit markets here, James, some might say that the low hanging fruit is gone. It's been picked, so where are you finding value these days? Is it as simple as saying, "Buy tech because everyone is working from home, and stay away from travel because fewer people are vacationing?"

James DiChiaro: No, it's not quite as simple as that. And to start, I agree with just about all of Tom's comments earlier. I mean, I don't want to say that the worst is behind us for corporate credit, but it is important to note that profit margins did increase in the second quarter, so revenues contracted a little bit more than EBITDA did. Interest coverage has gone down, or actually gone up a bit given lower rates while leverage ratios have increased somewhat, right? I think the important takeaway here is that they didn't lever up for no reason. They were building up their balance sheets, repairing up their balance sheets, and ensuring that they had enough cash on hand to withstand some of the uncertainties that they were dealing with, with being faced with COVID-19. But one thing that we're starting to see at Insight is that there's different behavior amongst different corporations at the board level.

James DiChiaro: So you have some entities that are still playing defense, still guarding for continued and perhaps increased contractions in revenues, while there are some entities that seem that some of the cash-raising they did in late first quarter and second quarter, I don't want to say that it's not needed, but that they're looking to deploy that capital for better purposes. We're starting to see a slight uptick in M&A. We had a few announcements recently, but what I also think is important is that we're not seeing any activity that's detrimental to fixed income investors. I haven't seen any large share buyback programs or things along those lines. So, I would say just to expand a little bit on Tom's comments, we do think there's a ton of value in corporate credit. Yes, the low hanging fruit is gone and it's largely a security selection game. And one of the ways to play that is to look at some of the more exposed sectors to COVID-19.

James DiChiaro: Find the larger players in that sector, ensure that they have enough liquidity on-hand to meet their obligations for the next 12 months or so, and we've found that there can be some effective returns made using that sort of style. But we would caution against owning generic beta in any asset class, for the most part.

Jenna DagenhartAnd turning to the Fed now in response to the pandemic, the Fed has taken drastic measures to try to stimulate the economy, from buying bonds to slashing rates close to zero, which leaves us in this new lower for longer environment. Oleg, what do you think will be the long-term impact?

Oleg Gershkovich: Yeah, I think that's a really important thing, and everybody is talking about that, the inflation, what's happening around the world and the Fed and Congress, will they release stimulus or not, these are really interesting times. The Fed has told us that they're not raising the front-end rate anytime soon and they've kind of changed their inflation make-up strategy. So, I'd say we think that there's another chance of a recession at some point in the next decade, which leads to low yields, and that only leaves kind of a handful of years for which where we can see the front-end rates move higher. So, with that view, we think that because of all of this, we have the 70 or so basis points of nominal yield on the 10-year treasury, and it's going to be hard or challenging for the levity to come into this space.

Oleg Gershkovich: And as you look globally at the central banks around the world, they've struggled to obtain that 2% inflation target. And that could be a forewarning for us in the US, in terms of finding the conditions right for a hiking event. It just may not come to pass. So, with the yields, kind of real yields are negative at this point. We're kind of expecting that it's going to be lower for much longer.

Jenna Dagenhart: And given the low level of rates, Tom, does it still make sense for pension funds to hedge interest rate risks?

Tom McCartan: It still does make sense for pension funds to hedge their interest rate risks, Jenna. It’s a risk management strategy and I think U.S. interest rates are only really low from the perspective of looking in the rearview mirror of where interest rates have been far in the past in 2019. I think a better example of where interest rates could go, and here I’m really referencing the back of the U.S. yield curve which is where pension plans and liabilities are most sensitive. So, let’s think about the U.S. 30-year bond at 1.4% today. You know, the better examples of where that could go, as reference points, are for instance Europe and Japan. Those aging, globalized, post industrial economies where the low potential GDP, low inflations,  low rates. Relative to those rate structures, US rates appear really high, and in fact, the bond actually stands out as very cheap. I think there is still a very strong case for U.S. pension plans to be increasing hedge risk.

Jenna Dagenhart: Tom, building off of that, are there any behavioral biases going on with rates?

Tom McCartan: Yeah, I think you can certainly identify a couple. I think investors are anchored to the levels of rates that feel more normal that they remember from years past and it is often not the best way to think about whether you should hedge or not. I think a better more objective framework for pension plan and asset liability structure to think about is to think about it really in risk and return space. And risk the funded status and return funded status. And actually when you do that you can make an incredibly strong case for increasing the hedge ratio. So, stepping through that, a fixed income allocation unchanged, a higher ratio means more returns. That means the yield curve is steep, getting a higher yield, getting more term risk premium. At the same time, you’re actually adding convex, which is improving the distribution of those return risk.  So, you’re adding convexity, you’re adding return- so what do you have to give up in risk? Actually, your risk goes down. Funded status volatility falls from increasing the hedge ratio.

Tom McCartan: So, this is almost having your cake and eating it; this is like the holy trinity of what investors are actually looking for. There’s very few traded out there for any investor where you can improve return, improve your profile of your return distribution, your convexity, and lower your volatility at the same time. So, when you consider all that, there is a very, very strong case for pension plans to increase hedge ratios.

Jenna Dagenhart: And James, talk to us a little bit about the trajectory of the economy and your thoughts on the Fed given the renewed focus on labor markets and unemployment.

James DiChiaro: Sure, sure. I would start by saying I agree with just about everything that Tom said earlier. As far as the trajectory of the economy, I mean, from my perspective, things aren't great, but they're certainly not as bad as feared. I mean, we had a 30-odd percent draw down in GDP in the second quarter. And we're seeing reasonable bounce back in the third quarter, thus far. I mean, Insight's expectation for GDP for the full year 2020 is negative 4%, which in the grand scheme of things considering what has happened, isn't really the worst-case scenario. And obviously you guys have seen the gains in the employment space, so things are headed in the right direction there.

James DiChiaro: And as some of the other speakers mentioned, there's quite a bit of both monetary and fiscal stimulus in the market, which is really supporting credit. But focusing a little bit on the Fed and interest rates as was mentioned, the Fed has indicated they're not moving interest rates for the next three years. So that we know. That leaves very little room for the two-year note and the five-year note to move.

James DiChiaro: But I think where there is more of a debate is longer out on the curve with the 10-year and the 30-year part. And just some of the points that Tom made earlier, we all have a high reference point in our life. We're all used to seeing rates higher than where they are right now, so in the back of our mind, we fear them going back there. But there's a cost to sitting on the sidelines and not being invested in this market. And that is, you missed 14% on the long bond last year, and 20-odd percent on the long bond this year. But as far as interest rates are concerned specifically, there's really two fairly entrenched camps, as far as I can tell.

James DiChiaro: You have one camp that believes that all the fiscal and monetary policy stimulus and easing will eventually lead to an uptick in dead issuance, which will eventually drive some inflationary pressures and lead to higher nominal rates. Then you have the flip side, which Insight's a little bit more in the camp of, which is that we have a dearth of yield globally. We have $16 trillion of negative yielding debt globally still. So, we struggle to engineer 2% inflation prior to COVID-19 when things were going pretty well and GDP was growing in that 2% range.

James DiChiaro: I'm just not so sure that we should be afraid of higher rates and inflation in an economy that is not back to normal, and you could make an argument is still contracting to some degree, or at least sorting out who the haves and the have nots are. So, our opinion would be a little bit lower for longer in here. I think that if the longer end of the curve actually went much higher, as in 30-year maturities, I think to Tom's point, there's overseas investors who would view that as an attractive investment opportunity and would jump right back into the market. And then the other thing that the Fed has at their disposal, they haven't talked about it in a few months, but it's yield curve control.

James DiChiaro: It's not in this country's best interest to have interest rates move up materially, given the amount of debt we're expected to issue. We need to maintain a decent level of debt service coverage. The Fed is buying treasuries, they're buying mortgage-backed paper. Those are both rates products. And they retain the option to engage in yield curve control to the extent the curve got too far out of whack. So, given all of that, our opinion would be lower for longer.

Jenna Dagenhart: And Oleg, anything that you would add to that and specifically about debt issuance?

Oleg Gershkovich: There's a couple of things I'd like to mention, and I agree with James and Tom. Definitely lower for longer. I just wanted to go back really quick to the does it make sense for pension funds to hedge the interest rate risk? I 100% am an advocate for pension plans always hedging their interest rate risk, even in this low level of rates. I think it's extremely important that that risk be addressed. I think it's the biggest risk for a pension plan. At the end of the day, these pension funds are paying out a liability, a set of cash flows that are in essence, bond-like promises in an annuity contract system that is basically a bond promise from the sponsor to the employee. So, there's kind of this connection with rate moves in how the liability is determined. Then I understand that there's all sorts of flaws and there's no downgrades in the liability curve construction, but there is in the fixed income portfolio.

Oleg Gershkovich: But nevertheless, when rates are low, even at these levels, I think it always makes sense to de-risk and duration match those cash flows. Because if rates move even lower and it's not impossible, but if they do move even lower, the increase in liability is going to be even much higher than it was when rates were 5, 6, 7% back in 2007 or 2002. And because of the convexity, it'll hurt plan sponsors much more and these pension plans are essentially non-profit insurance companies on a corporate's balance sheet. So, I think it's very important to hedge probably, arguably the biggest risk in the pension plan, which is the interest rate risk. But since rates are this low right now, it also is cheap to borrow money.

Oleg Gershkovich: So it may make sense to issue debt, get that cash, fund the pension plan, close the gap. You get a tax deduction in doing so, and if you do that, you might hit a couple of triggers on your glide path. So, you then de-risk, you get more fixed income, duration matches always, and you might... You should decrease your surplus volatility, which I think is kind of job number one for these LDI strategies.

Tom McCartan: Yeah, I think that is a great point by Oleg. I do think that now the whole rate structure has shifted down, I do think you’re going to  see a lot more of that borrow to fund activity, where the other thing you’re eliminating is not just the tax benefit, but you are eliminating the PBGC variable rate premium. And, when we think that that’s at 4.5% of the deficits in a pension plan, is essentially the entire IG market can borrow a coupon less than that, and probably a huge part of even the sub investment grade market can borrow a coupon less than 4.5% as well. So, I think that is something to watch out for in the future, more of that borrow to fund activity as well.

Oleg Gershkovich: And if I may, Tom, you bring up a good point about the PBGC. Those premiums are definitely a drag on your assets at like four and a half cents. So that's kind of an easy pick up. And I agree. And so, I would just say if the sponsors can take care of everything else, they need to take care of during these volatile times and then go and raise the money, I sometimes feel like the pension plan might be an afterthought for a lot of the businesses that are just struggling to hang in there. So, I think if they can and they've taken care of everything else and they've got the CFO's attention, then that's definitely a strategy and so, I'd love to hear anecdotes of how that's happening if you guys are seeing anything like that. But I do agree, and I expect that to happen. It just makes economic sense.

Jenna Dagenhart: Tom, could you elaborate on spread portfolios, and their construction?

Tom McCartan: Yeah so we have talked quite a bit on the interest rate of the equation of the liability for pension plans. And Oleg just referenced this high-quality spread that’s also built into the discount curve. Now the spreads are all labeled double A, but in reality, they are not really double A when you look at the amount of spread that is actually implied in those discount curves. So, I think when you come to think about the spread portfolio construction, that’s the first thing you need to do, really analyze and understand how much spread is embedded in the specific discount curve that the pension plan is using. The range right now is about up to 100 basis points between different actuarial discount curves provided by different firms.

Tom McCartan: So, it really tells you how much return, not just in Fixed Income but the entire asset portfolio, needs to earn over the risk rate in order to keep the funded status stable. Once you’ve done that, you can start to think about portfolio construction. There is, i think a temptation because those discount rates are based on this quite small, narrow, double A investment grade market. There is temptation to concentrate the portfolio construction on that part of the market and it’s not always the best idea.

Tom McCartan: I think what it has suffered from is really being the preferred habit of many LDI investors. So, both pension plans and insurance companies really do concentrate a lot of their assets in that part of the market for not necessarily total return economic reasons. So, the long term risk adjusted returns really have suffered. But, in reality, just like Oleg has mentioned, the liability is really risk free, in essence. That double-A sensitivity is created by the accounting convention. And so, potentially a better approach in thinking about the portfolio construction is thinking about it as risk free and think about earning that risk premium, or that excess return from any assets and thinking about just maximizing just risk adjusted return, rather than from this asset class that is somewhat arbitrarily linked to the pension valuation, those really high quality long IG bonds. So, those are some of the considerations we will try and bring up with plan sponsor groups as we start to think about best type of portfolio construction within LDI.

Jenna Dagenhart: And I know we've talked about how the Fed isn't really even thinking about thinking about raising interest rates. James, what are some of the risks though of a move higher or on the other end of the spectrum, what about further easing?

James DiChiaro: Yeah, I mean, I'll address the easier question first, which is a further easing. I mean, I know that's something that the Fed has commented on before, is something they're reluctant to do but they haven't firmly ruled it out. To me, in order for that to occur, we would have to have another leg down in COVID or another contraction in economic growth. Conversely, I think the biggest driver of interest rates moving higher near-term would be inflation. But at Insight, we actually had a pretty good conversation about the linkage between inflationary pressures and nominal treasury yields. We're starting to begin to think that perhaps there could be a break in the linkage between rates and inflation. And the reason that I say that is that you have the Central Bank, which is effectively monetizing much of the debt issued by the US.

James DiChiaro: So to the extent the fiscal deficit really grew to quite a bit, there exists at least a possibility that the Fed could continue quantitative easing or yield curve control, thus monetizing more of the debt and not actually leading to higher nominal interest rates. I.e., we'll have currency inflation. But I think that both of those scenarios are relatively unlikely. One thing that did strike me when both Tom and Oleg were speaking, and I'm certainly not a pension expert, but in thinking about both the interest rate curve as well as the corporate credit spread curve, and knowing that pension assets tend to be of longer duration and given some of the aversion to buying longer duration assets, given an expectation for higher interest rates, I do wonder if it makes sense to err on the side... and I think they kind of alluded to that, err on the side of being invested rather than not being invested. Because the other thing I would highlight on long data corporate credit paper is that the long bond's trading at roughly 1.4 or 1.5%. It's very possible to buy a corporate credit bond that's low single A, high BBB rated around 150 spread.

James DiChiaro: So, what that means is half of your coupon will consist of pure interest rate exposure, while half would consist of credit spread exposure. Those two elements don't always move in the same direction. And in fact, there's some negative correlation there. So, to the extent you see a higher pressure on interest rates, you could actually see some downward pressure on credit spreads, which can sort of keep the price of the bonds stable, allowing you to earn carry. So, from my perspective, it doesn't seem to be a terrible time to be invested in the long end of the curve if you can get comfortable with some of the technical out there and the fact that I really don't see inflation picking up materially near-term.

Jenna Dagenhart: Especially with that negative correlation.

Oleg Gershkovich: I believe we actually even witnessed some of that happening, if I recall maybe in April and May. So that definitely, we saw rates drop, we saw everything drop. Credit spreads too, maybe moving 100 basis points just within March, within days. But then as April came, if I recall correctly, we saw the rates drop with the credit spreads maybe widened, and its kind of just left this neutral position in some of those rates for discounting liability cash flows.

Jenna Dagenhart: And taking a closer look at diversifiers now, Oleg, how are you using diversifiers to improve fixed income allocation and how important is security selection? Do you worry about concentration risk?

Oleg Gershkovich: Absolutely. Thank you for asking that, and I loved what Tom mentioned earlier about liabilities pension plan promises being a risk-free promise because in essence, come hell or high water, these benefit payments have to get paid. So, in the purest sense, they should be discounted at a risk-free rate. But using how Tom mentioned the rate structure and then building on top of that, that gives you room to get creative, because definitely when they're seeing up liability valuations and the actuarial firms have all their really cool curve constructions, and there's some creativity there, let's be honest. And maybe that's incentivized by the accounting rules. I would kind of agree with that.

Oleg Gershkovich: There's kind of room here to create really interesting portfolios that maybe can address certain things like concentration risk. So, once you do set the benchmark, many fixed income managers, sponsors will have... They could have two, three, several fixed income managers and they'll all get a benchmark, and they'll pile into the same bonds. And it becomes incredibly important for plan sponsors and their managers to diversify. Because what we don't want is if there is a downgrade or default or some sort of structural issue within that allocation, that concentration risk can become a real risk to the pension, to the pension plan asset portfolio.

Oleg Gershkovich: So, what we try to do at Voya is we look for investment grade products that are beyond the traditional long of credit products. So, products such as securitized credit, or private placements. We come from the old ING insurance company, so it's kind of within our DNA to have those private placements which are very common with insurance companies that manage similar books of annuities for within their own general account, as well as CMLs. So, the first step is to kind of build the foundation of long corporate bonds within the pension plan assets, and that's a great way to hedge that long data liability as we just talked about with James and Tom.

Oleg Gershkovich: And that serves as the core of any hedging allocation, but then we loop in these other products, and we've even constructed portfolios where there's a securitized credit allocation, CMOs, private placement with only a 15% allocation to investment grade corporates. And the idea there is we can get a greater yield, outperform the liability growth, a better option-adjusted spread, and still deliver a relatively low tracking hour to the liability. So, when we look at structuring something like this, it's got to be worth taking on maybe a slight increase in tracking, in tracking [inaudible 00:36:18] to the liability. So, for instance, there's structural protections that you get from securitized credit and private placements.

Oleg Gershkovich: So we're happy to include those, knowing we get that benefit at the price of maybe a little bit tracking our... or there's the higher expected return from private placement. So that's another bonus that we love to have, or a government guarantee in the CMO space, so that's something else. There's no downgrade default risk there. So, as long as we can structure a diversified portfolio, it's not going to look traditional. It's not going to be the AA bonds that are in the Barclay long gov/credit. But you know what? It can outpace the liability return, and it's a great risk-adjusted return, and maybe we'll increase a little tracking error, but at the end of the day, we're not overexposed to any single sector asset class.

Jenna Dagenhart: And we'll talk more about tracking error later in the program, but before we get there, Tom, talk to us a little bit about our multi-sector approach.

Tom McCartan: I mean, if you buy the argument that I was previously making about LDI preferred habitats and the core incentives that the accounting framework can create, then you will naturally gravitate towards a somewhat less silent approach where you are not really thinking about that traditional construct of just t these are growth assets and those are hedging assets. You will think more in terms of ‘How high do I want to get my hedge ratio and how can I achieve the hedge ratio’, and then ‘how much excess return of the risk-free rates do I need?”. And then you are identifying sectors both within fixed income and outside of fixed income that are going to get you that excess return and maximize risk adjust return while doing that.

Tom McCartan: Specifically in Fixed income, I think it’s somewhat almost the converse of that preferred habitat theory of some of the opportunities we look at. There are asset classes, while I mention there is high quality investment grade corporate suffer from this preferred habitat where there are large amount of investors that for non-economic reasons create too much demand for those asset classes, there are also asset classes that there is under demand for non-economic reasons. For instance, securitized assets, sub-investment grade assets, they are somewhat arbitrarily excluded from most of the public fixed income indices. So, no passive buyers buy them, no very index focused investors buy them. And then, they are almost always, in any institutional mandate that I come across, there are constraints on the allocations for those sectors, which are not necessarily economic strengths.

Tom McCartan: So, those are some of the areas where we find value, where somewhat similar to what all of you mentioned, we like to try enhance the risk adjusted return in a portfolio, but we always do still need to be cognizant of ‘are the plan sponsors going to mark the liabilities with this double-A curve at the end of the year? So part of it does become: how do we maintain risk control without liability while including some of these risk adjusted return enhancing traits within the portfolio construction.

Jenna Dagenhart: And I know as Tom said earlier, what hasn't changed in 2020? So that being said James, the world is full of uncertainties, highlighting the need for diversified fixed income within your portfolio. How are you achieving this?

James DiChiaro: Yeah, so I can speak on behalf of the Core Plus strategy that we run, which is a highly diversified mandate. And it's benchmarked against the US aggregate index, which is primarily two-thirds to three-quarters rates type products being US treasuries and mortgage-backed securities. We've took it upon ourselves to have a base over weight, investment great cred for some of the reasons that we referenced earlier. While at the same time, we've also been increasing exposure to US treasuries, to guard against some of the volatility that's in the market right now, as well as take advantage of the some of the steepness of that treasury curve while also increasing exposure to MBS. Now MBS is not a very high-yielding sector, but it can display very high degrees of total return performance at times. So, to take a step back and I should have mentioned this earlier, the Core Plus strategy is a little bit less focused on liability matching. In fact, it's not focused on liability matching.

James DiChiaro: It's more focused on deriving sustainable sources of income while also providing ballast against some of your equity portfolios, meaning a little bit more of stability and less volatility. And the other thing that we've actually been running in this portfolio against that treasury and mortgage exposure are very select high-yield exposures. Now again, the high yield asset class is not one where you want to own generic beta. There is an expectation that there will be continued pressures throughout the rest of the year and defaults are expected to be elevated. So, it can be a dangerous game for inexperienced investors. However, having a very detailed analyst team, working very closely with them, we're able to identify some security selection candidates within that market that offer very attractive, contractual sources of yield. Now, the one area that we're perhaps a little bit more cautious on would be the asset-backed security sector, or securitized.

James DiChiaro: As most of you very well know, that tends to be more of a mathematical or statistical gain, various tranches with various levels of over-collateralization. And it's also a sector that's sort of built off of retail, and retail spending habits have changed over the last six months, and as I mentioned earlier, there will be some winners and some losers. The other thing that's a little bit nuanced about AVS is where you can go into a corporate boardroom and see the various players who have access to different levers to help them get through some of the volatility and some of the issues they're facing, the securitized sector doesn't necessarily offer that. To the extent you burn through credit enhancement, that's it.

James DiChiaro: So, a bit cautious there. Emerging markets, look, they have some downside risk to the extent COVID flares up again. They're not all created equally. Some of the investment-grade EM issuers are in decent shape. Some of the ones that aren't overly reliant on oil imports are doing a little bit better as well. So, we're diversified across all parts of the fixed income spectrum. Not limited to treasuries, mortgages, credit, CMBS, ABS, et cetera.

Jenna Dagenhart: Now, spending a little but more time on liability benchmarking, Tom, what's the best way to track and pen performance?

Tom McCartan: So, I think as plans get further down the LDI path, get higher fixed income allocations, and really do try and de-risk and refine the LDI strategy, I think liability benchmarking can begin to make a lot of sense. What it really starts to do, is to move the LDI managers incentives closer to what the plan sponsors ultimate objective is, which is to manage funded status volatility and manage funded status risks. It starts to change the definition of alpha from just being a market index to actual improvement in market status.

Tom McCartan: It addresses some of the misalignments that are contained in managing versus market index when in fact the liability is really risk free. And it also addresses some of the concentration risks you have in some of those market indices where certain large issuers, certain large industries, can be really high percentage weights in the indices. I think some of the considerations you need are really strong attribution from the manager to figure out what parts of the liability return are actually un-investable, because there are some un-investable elements to that due to fluctuation in discount curves, and also the lack of credit migration that liability has. But when you do that, where you provide that attribution, you are really giving the plan sponsors the transparency and the clarity that they need to understand why the funded status is changing and what were really some of the driving factors that caused some changes in the funded status.

Jenna Dagenhart: Quickly building off of that, Tom, what's your take on low tracking error and passive LDI strategies?

Tom McCartan: We are not fans of low tracking error of passive LDI strategies. It gets back to some of the points already made, about this being somewhat of a preferred habitat problem in risk adjusted returns in certain parts of those sectors. And you really don’t want low tracking error to restructure each sector. I think there are some LDI managers that would manage with very low tracking error, but what it’s really doing is locking in that credit migration loss of those indices relative to the liability which experiences none of the effects of credit migration.

Tom McCartan: And it is providing the plan sponsors with the false sense of the actual success of what the demand is. That low tracking manager might be beating the index by 10 or 20 basis points, but how much is the index flagging their liability due to credit migration? And that could be closer to 100 basis points over the long term. So, I think it’s not helpful in that respect, and some plan sponsors just may not realize just the amount of [inaudible] that is actually needed to keep up, as Oleg mentioned, and to keep pace with a liability that earns 120-150 basis points a spread, but has no credit migration risk at all.

James DiChiaro: And Tom, going back to the low tracking error strategy, is that effectively saying index-like, which is effectively owning more credit beta, than not? Which I would kind of say is kind of a dangerous game in this environment.

Tom McCartan: Exactly. Exactly, James. And just really owning the credit beta and potentially not owning the best rewarded beta in credit markets is actually probably some of the lowest risk adjusted or lowest amount of award per unit of risk in credit markets out there. But you know, there is a ton of inertia in the market, there is all these managers who’ve got long track records and composites and is very established. So, I do think, I’m hopeful that that’s going to be one of the areas to be addressed in the future.

Oleg Gershkovich: If I may jump in, and by the way, I love the preferred habitat phrase that Tom keeps using. That's really a great way to describe it. The benchmarking and the tracking error, I mean, we have to kind of take all that with a grain of salt, because there is kind of the aspect of false precision that comes into play when we talk about tracking error, especially to a liability where they set it once a year, they come up with some curve that may include Qatari bonds or Chinese bonds or who knows what, and it could be a super-thin AA market, and it's just... It's kind of rife with these idiosyncratic issues in terms of curve construction and liability discounting. But nevertheless, something's better than nothing.

Oleg Gershkovich: You'll get a little bit more accuracy. And to have the explicit benchmark go back to the liability, explicitly benchmarked to the liability, I think is really important especially when you're in the upper echelons of your funded status and your hedging program. And then you really want to make sure you're tracking your liability, even with understanding all of these kind of pitfalls in doing so. It's better than not doing it, and you'll get a closer, better result over the long term. But to continue to benchmark in an index, which many managers do as Tom points out and they're kind of in this maybe mindset of, "Let's just be the Barclay Long of credit benchmark," they might miss the point. They'll miss the actual liability, and then who owns that difference? Is that difference owned by the fixed income manager or the plan sponsor?

Oleg Gershkovich: And the difference I'm referring to is the difference from the benchmark to the actual liability. And so, as long as we're mindful of how the liability is moving, I'd always say keep an eye on the liability. I'd keep an eye on the risk-free measure of the liability. I'd keep an eye on the credit-based, like a pure market credit-based, an AA-based. Nothing fancy from your actuary, but just a real market-based liability. So, your kind of always have your hand on the pulse of what the liability is looking like from several different lenses. And then if you don't have one, maybe consider a completion manager to help fill in the gaps for your roster of fixed income managers to make sure your key rates across the curve are matched between your liability and your asset, your pension plan asset portfolio.

Jenna Dagenhart: And Oleg, how can derivatives be used to hedge risks? How do derivatives compare now to before the financial crisis?

Oleg Gershkovich: Yeah, that's a really important feature, especially when we're talking about completion managers and being able to fill those key rate durations in across the curve, is it's very easy to just put on a derivative like a treasury future or a swap and their kind of was this reluctance to use derivatives over the prior decade. And I think a pitfall of having a glide path was many sponsors thought that they were de-risking, but maybe they never hit a trigger.

Oleg Gershkovich: So, I'd say you can always have a derivative kind of help you get the interest rate hedge that you need. But there was this reluctance as I mentioned, they were considered maybe exotic instruments during and right after the Great Financial Crisis happened, but now we're seeing an uptick from sponsors asking, "How does this work?" And we have clients that have been using them successfully for many years now. And I think as underfunded smaller plans are increasing their fixed income allocation, they may still fall short of the duration target that they need to get. And so, may now have to resort or look at derivatives as a way to supplement and minimize their interest rate risk.

Oleg Gershkovich: It is relatively straightforward to put these on. And it does deliver more interest rate exposure per investment dollar, allowing a smaller portion of assets to address interest rate risk while keeping your growth portfolio or your return-seeking portfolio intact, which is kind of a great way to have your cake and eat it too, if you will. And then as you get better funded, you can then transition into physical instruments and have your fixed income portfolio refurbished that way. And to answer the last part of your question about how has it changed since the Great Financial Crisis, I'd say with the passage of Dodd Frank, there's been heightened regulation in the over-the-counter derivatives market.

Oleg Gershkovich: So, the effort there was to reduce the risk, increase transparency, and have a mandatory clearing house through which all of these trade through, which I think has reduced a lot of the counter party risk or counter party insolvency issues with derivatives. So, I expect that there will be more appetite. We already see it happening, and as I mentioned with completion managers, it's instrumental in duration matching, cash flows, and assets.

Jenna Dagenhart: And Tom, economics always catches up with accounting, which creates a bit of a portfolio construction conundrum headache for plan sponsors. How are you working to help plan sponsors strike the right balance?

Tom McCartan: Yeah, I think there are many instances across investing where economics diverse and they distract investors from identifying best relative value and create portfolio conundrums and headaches. I think DB pension-fund investing, that’s one of these classic situations, where plan sponsors are trying to ask the question: ‘how do I optimize both of these, how do I optimize in the short run for my accounting valuation versus my double A liability, and how do I optimize for the long term?

Tom McCartan: And unfortunately, you can’t. You can’t get two objective functions. So, often times what we try to do is help and advise on how do you strike the balance between those two objectives? And what we are trying to do is, on the plan sponsors with the quantification of what the benefits are, what the risks are, arm them with the analysis they need to educate committee members and get decisions made through the various different governance structures. And often times the communication around the results is just as important as the analysis itself.

Jenna Dagenhart: And Oleg, going back to my prior question, what can corporate plan sponsors learn from the L-shaped recovery of funded status since the Great Financial Crisis?

Oleg Gershkovich: Yeah, the last decade, I kind of always heard this refrain during that decade of, "Rates are going to rise, rates are going to rise, and I'm going to wait for rates to rise and then I'm going to de-risk." Well, guess what? Rates never rose, and we saw a 300-basis point drop in rates over that decade. So, we decided to write a paper about it. We call it The Lost Decade, and essentially what we saw was of the S&P 500 companies that have a defined benefit pension plan, that have publicly available 12/31 data, we looked and in aggregate, we saw a 30% drop in the funded status from 12/31/07 to 12/31/2008. But the retracement since then was only one-third of the way back, as of 12/31/2019. And this is roughly on a trillion dollars of liabilities and assets of the companies, about 160 that were in our study.

Oleg Gershkovich: And that's kind of amazing if you think about it, because to only retrace such a small amount after that precipitous drop during the biggest bull market over the last decade, during rate rallying the way they did. And in addition, these companies in aggregate put in a half a trillion dollars in contributions during this time frame. So, despite all of that and some wind in their sales, it was a little surprising to see that they exhibited this L-shaped recovery, which is to say maybe not really much of a recovery, despite all of these advantages that were there for them.

Oleg Gershkovich: And I think the lessons that were really learned were you can't really depend or count on interest rates to bail you out in pension or LDI... in pension investing because rates can really work and hamper your ability to surmount them within your pension plan, if you're not adequately matched. And that's not to say that if it was just a fixed income allocation, they would have done better. They definitely would need the contributions, but you've got to do it smartly and you've got to do it in a risk-managed way and I think a lot of the interest rate risk exposure really, really hurt a lot of these corporations.

Oleg Gershkovich: In general though, towards the end of the decade, we saw the big increase from this group in our study, that they were starting to shift to fixed income, that there was kind of this bump up in 2018 to make contributions because of the tax change, so a lot of them took advantage of that and then de-risked. But also, the bipartisan Budget Act, which increased the PBGC premiums very markedly and I would argue its kind of indexed to inflation.

Oleg Gershkovich: And at four and a half percent right now, I think that really woke up a lot of the plan sponsors that they decided to contribute, de-risk, and so we did see lessons learned not only from kind of the faulty mentality of waiting for rates to rise, but also from... or maybe guided by regulatory movements, that kind of propelled sponsors to de-risk. And then COVID comes along and that was basically a final exam for these LDI strategies. Did it work? And we saw that maybe, there was a muted effect in funded status declines because many now have a better strategy than they did back in 2007, and those that really contributed and completely de-risked, that were 100% funded, 100% hedged, they survived Q1 very well during a very unstable time.

Jenna Dagenhart: And as we wrap up this panel discussion, I like to end by looking forward. James, you mentioned inflation earlier. Do you think that inflation concerns could be overblown at this point, or should we be worried about inflation servicing in the years to come and likewise, are there legitimate reasons to why deflation or dis-inflation might still be a concern?

James DiChiaro: Yeah, sure. Look, I think the market will be focused on inflation near-term. It's going to be looking for any signs of inflationary pressures, and I expect that you'll see both nominals and TIPS yields react quite substantially to that. But I think over the longer term, inflation is going to fail to live up to expectations. And I'm just not a long-term believer in buying protection against inflation at this point. I think more needs to be seen on the growth front. I think really yields need to be a touch higher before we start getting inflationary pressures.

James DiChiaro: Capacity utilization is only 70% right now, so we still have quite a bit of slack in this economy. We need to work through that before we start worrying about real inflationary pressures, in my opinion.

Jenna Dagenhart: And Oleg, where to take your fixed income from here? Traditional long duration has done well, however, exploring other fixed income products to avoid concentration risk and diversify the LDI portfolio warrants consideration as well.

Oleg Gershkovich: Absolutely. And we spoke about those topics. So, looking at securitized credit and private placements to kind of build out a really strong and a robust portfolio I think is very important. The other things I'd add are let's always go back and keep an eye on the liabilities and the cash flows. I don't think you need to have a close frozen plan necessarily to have the right de-risking strategy.

Oleg Gershkovich: I do believe in contributing service cost, and keeping a good, healthy fixed income allocation is a great way to reduce volatility, even in open and accruing pension plans. But always keep an eye on the liability, always keep an eye on are there lump sum provisions in the plan? Is there cash balance structures in the plan? I mean, that might be a topic for another time. But those are certain things that we need to think about, and that you can use your fixed income portfolios to address those issues.

Jenna Dagenhart: Tom, turning to you, looking forward, what are the future refinements plan sponsors should be thinking about for their LDI strategies?

Tom McCartan: Firstly, I think rates could be low for a long, long time. So, I think changing people’s mindsets to making the decision on interest rate hedge ratio not based on where the level of rates is, and where they think the level of rates should be or could be, but rather pulling back in the capital markets theory and thinking about the risk and return of hedging interest rates and not hedging interest rates I think is a requirement that needs to happen.

Tom McCartan: And then secondly, I think as the pension community as a whole continues to de-risk in lower funded status volatility, I think the next big topic to be addressed needs to be benchmarking. And it needs to be thinking about how to create better benchmarks that are going to create better alignment of interest between LDI managers, what plan sponsors are actually trying to achieve, and doing that along with thinking about more multi-sector approaches and wider guidelines and greater toolsets to actually achieve the outcomes plan sponsors are looking for.

Jenna Dagenhart: Well, appreciate your time, everyone. We've covered a lot of ground today, including how to perhaps have your cake and eat it too. So that being said, thanks so much for joining us.

Oleg Gershkovich: Thank you, Jenna.

James DiChiaro: Thank you, Jenna.

Jenna Dagenhart: And thank you for watching this LDI Masterclass. I was joined by Tom McCartan, Principal of Liability-Driven Investment Strategies at PGIM Fixed Income, Oleg Gershkovich, LDI Strategist and Senior Actuary at Voya Investment Management, and James DiChiaro, Senior Portfolio Manager at Insight Investment. And I'm Jenna Dagenhart with Asset TV.