Lower-Rated Bonds May Improve LDI Strategy

BBB-rated corporate bonds merit important consideration in the asset allocation of pension funds implementing liability-driven investing (LDI) strategies, Standish Mellon Asset Management contends.

BBB-rated corporate credits may provide diversification, incrementally improved returns and other benefits to U.S. corporate defined benefit (DB) plans that typically invest in A and higher-rated securities in their LDI strategies, according to a white paper from Standish Mellon Asset Management Company LLC, fixed income specialist for BNY Mellon. 

“BBBs are still investment-grade securities, for those concerned about credit quality,” Andrew Catalan, managing director and senior portfolio manager for Standish in Boston, and an author of the report, tells PLANSPONSOR. “As you move down the rating scale, the increase in the spread over Treasuries, or overall yield, is itself enticing, but we recognize there is concern about additional risk,” he says. “If you can select BBBs by analyzing the company and coming up with the conclusion the investments will remain investment grade or even be upgraded, you have a chance to harvest the returns which will be higher now than that of higher rated corporate bonds.”

When considering how to best meet or exceed the liability return, DB plan sponsors recognize that the liability discount rate is developed by using AA-rated bonds for accounting purposes or A to AAA for pension funding and other statutory purposes under the Employee Retirement Income Security Act (ERISA). Catalan explains that plan sponsors have the frame-of-mind that since AA is used to discount liabilities, their assets should be in AA, but Standish finds BBBs correlation to A-rated or AA-rated bonds is fairly high. “So, plan sponsors are not reducing their hedge against risk by investing in BBBs,” he says.

According to the white paper, Standish did an analysis assuming the Barclays Long Corporate Index and its various quality sub-components (A, AA, etc.) are proxies for liability discount rates. It then isolated the impact of different durations across these indices by using excess returns. It found the correlation between the Long BBB Corporate Index and the Long A to AAA and Long AA indices has been 94% and 88%, respectively, over the past twenty-five years. More importantly, the Long Corporate Index, which comprises 47% BBBs, is very highly correlated with both the Long A to AAA and Long AA indices with correlations of 99% and 94%, respectively.

One of the reasons for the high correlation, Catalan says, is that a lot of BBBs have long duration. DB plan sponsors are increasingly turning to longer duration fixed income instruments for their LDI strategies (see “Mulling a Graceful Glide As Funded Status Rises”). “If plan sponsors restricted themselves to just A- or better-rated bonds, that is only about half the universe of long corporate bonds—which is not sufficient to meet pension plans’ demand for longer duration vehicles. They are missing about half of the universe,” he notes.

Catalan explains that the down economy and slow economic growth has resulted in the deterioration of credit quality for lots of companies, expanding the universe of BBBs, so BBBs offer more diversity than they did years ago.

According to the paper, the top ten AA-rated companies represent 83% of the AA universe as of the end of June per data from Barclays. As the paper notes, “it would not be prudent to hedge the liabilities with a portfolio that is highly concentrated in a few credits.”

Catalan adds that BBB-rated companies will try harder not to be downgraded and to remain investment-grade than higher-rated companies, so they will be more disciplined. He notes that higher-rated companies are pressured to return more money to shareholders. BBB-rated companies tend to allocate less of their cash than A-rated companies to share buybacks and dividends, which may result in more cash debt payments and reinvestment in the company, with the potential to improve the firm’s ability to meet future debt payments, the paper says. 

More reasons pension funds should consider BBB-rated corporate bonds can be found in Standish’s white paper, “To BBB or not to BBB, that is the LDI Question.”