Expanding the Credit Universe: Managing Credit Migration Risk for DB Plans

For defined benefit (DB) plan sponsors, inflection points in a credit cycle can have a dramatic impact on corporate bond portfolios constructed to hedge expected liability cash flows. Against a backdrop of growing BBB bond issuance, many plan sponsors are focused on minimizing credit migration risk as they build, implement and manage de-risking strategies.

To hedge against movements in liabilities, plan sponsors historically sought to replicate the performance of the AA-rated long-duration corporate bond universe. Most plan sponsors recognize that perfectly replicating the cash flow discounting process is impossible. Investors are subject to principal losses from credit events, while the factors used to discount cash flows are not. Essentially, the discount rate has no memory of downgrades.

Accordingly, over the last decade, many plan sponsors have judiciously expanded their opportunity set to include bonds in the lower-rated segments of the investment grade (IG) spectrum. At this stage of the cycle, concerns about credit migration risk have returned, especially with the surge of BBB issuance in the last decade.

The risk in BBBs: Know the facts

On the surface, the sharp increase in BBB-rated debt seems concerning, particularly against a backdrop of higher net leverage and declining coverage ratios.

While risk is present, we do not believe a downgrade cycle is imminent. Although leverage has increased for investment grade companies, much of this increase has been the result of M&A by larger companies with several levers to pull to ensure they remain investment grade. Further, many of these companies are higher quality, operating in defensive sectors, which should help insulate them from an economic downturn. More broadly, credit markets are still being supported by strong corporate earnings, as positive revenue and EBITDA growth help to offset higher net leverage and declining coverage ratios.

As the credit cycle has extended, there is increasing concern about BBBs and their growth:

• The growth in BBB-rated public corporate bonds has grown by 265% since 2007.
• BBB-rated bonds with maturities greater than 10 years have experienced the most pronounced growth, increasing by 270% over the same time period.
• The higher level of long-duration BBB debt is particularly concerning in the absence of natural buyers of long-dated high yield debt that is now nearly as large as the entire high yield market.

Despite this, we do not believe there is an immediate threat to the broader credit markets. However, for liability hedging portfolios, exploring ways to diversify credit risk without increasing the basis risk between the assets and liabilities is critical.

Minimizing credit migration risk: What is a plan sponsor to do?

The corporate exposure can be diversified through allocations to U.S. Treasuries and other government bonds. Another option is to consider nontraditional long-duration instruments such as Investment Grade Private Credit and Agency CMOs.

Given the track record of investment grade private credit during downturns, complementing public BBB credit exposure with this asset class can help enhance the risk profile of a plan sponsor’s credit portfolio. Diversification benefits aside, investors gain access to higher upfront spreads, ongoing prepayment and amendment income, and potentially lower losses.

It is important to be aware that adding these bonds may slightly increase the portfolio’s tracking error to the liability in normal times. It will depend on how the sector and sub-sector allocations of the bonds in the portfolios compare with those used to create the Aa-rated corporate bond yield curve used to calculate the liability value. During periods of low spreads and potentially increasing downgrade and default risks, having bonds with strong covenants that have historically provided higher recovery rates has the potential to produce better returns than a portfolio with just public bonds. As a result, since the liability can neither default nor get downgraded, a corporate bond portfolio that includes investment grade private credit should produce returns that better match those of the liability.

Securitized assets can also enhance diversification and mitigate downgrade risk. It is possible to construct a portfolio of securitized assets that matches the duration of the liabilities and consists primarily of agency CMOs with allocations to non-agency RMBS and CMBS that can further diversify the corporate credit exposure without giving up yield. Recently, we worked with a client to construct a portfolio that consists of 80% long agency CMOs, 14% CMBS, 4% non-agency RMBS, and 1% cash. The cash serves as collateral for the derivatives that are used to match the duration of the liability. This portfolio can potentially achieve a higher yield than the customized long duration corporate bond benchmark without eroding the significant diversification benefits of the agency CMO allocation.

Conclusion

Liability-driven investing (LDI) strategies will continue evolving to take into account changing regulatory and market conditions. As pension plans mature, their liability cash flows become more predictable. This will encourage plan sponsors to invest the bulk of their plan assets into fixed income strategies that more closely match liabilities.

Managing funded status volatility is critical to the success of any de-risking strategy. Plan sponsors should mitigate potential credit migration risk by expanding their investible universes and consider substitutes for investment grade public credit bonds including using investment grade private credit and securitized assets as effective alternatives for de-risking strategies. Investment grade private credit can enhance the risk profile of a plan sponsor’s credit portfolio and provide much-needed diversification from BBB-rated public credit bonds. Agency CMOs coupled with securitized credit sectors like non-agency RMBS and CMBS can add diversification to a portfolio without forcing a plan sponsor to sacrifice yield.

The nuances of applying these strategies depend on the objectives of each plan sponsor. Considering exposure to these strategies must be informed by the prevailing portfolio allocations in aggregate. Decisions around duration and illiquidity must be mindful of the liability characteristics, but there is certainly a strong argument to be made for this approach.

Pierre Couture, A.S.A., E.A., M.A.A.A., is senior actuary and portfolio manager with Voya Investment Management. Brett Cornwell, CFA, is a fixed income client portfolio manager with Voya Investment Management.