Falling interest rates, bond yields and credit spreads have created a wonderful tailwind for bond returns. At the same time, though, these factors also have increased the value of pension fund liabilities and have left some plans reluctant to lock in historically low yields through liability-hedging strategies. There’s a strong incentive for underfunded pension schemes to keep investing in return-seeking assets that aim to outperform their liabilities.
Many schemes accept diversified growth strategies that allocate dynamically to equities and other return-seeking assets such as private equity, infrastructure and commodities as an efficient way of earning equitylike returns with lower expected volatility.
Fund managers can adopt a similar approach in bond markets by taking an unconstrained approach to managing corporate credit, encapsulating exposure to traditional areas such as investment-grade corporates as well as to high-yield bonds, bank loans and emerging-markets corporate bonds. With a more flexible strategy, derivatives can be incorporated to manage interest rate duration — a factor likely to be integral to earning attractive returns when interest rates finally start to rise.
For institutional investors, there are two major benefits to such a credit strategy:
Maximizing total returns. Incorporating diverse sources of corporate credit returns into a portfolio, free from benchmark constraints, can help drive outperformance.
Retaining value. Actively managing duration and credit risk can help preserve value in falling markets.
A flexible approach to global corporate credit investing allows for timely portfolio adjustments in response to changing market conditions. More traditional forms of quality corporate credit tend to have high correlations to each other, though diversification can be improved by allocating to more extended sectors. Where such credit segments may be more dependent on duration as a source of returns, others, such as European high-yield and emerging-markets corporate debt, have more diversified sources of returns and provide enhanced opportunities for yield.
Pension funds historically tended to get their corporate credit exposure via traditional benchmark-oriented strategies. In such situations, the underlying benchmark generates most of the risk and return, and the manager takes overweight and underweight positions around the index to add value. Taking away the benchmark means there is no longer a reference point for measuring risk and thus requires a more holistic and multidimensional approach to risk management. Traditional measures such as value at risk, tracking error or volatility and effective duration are informative, but they fail to capture all the risks in an unconstrained portfolio that invests across multiple credit sectors.
Removing any benchmark linkage takes away an explicit measure of expected return. It is likely no longer a benchmark-plus-something; neither is it necessarily cash-plus-something. This untethered approach may present a challenge for plan sponsors or their actuaries and investment consultants when thinking about the contribution from an unconstrained credit strategy to overall plan assets. By extending the corporate credit opportunity set, however, an unconstrained approach allows investors to navigate today’s changing markets while maintaining an attractive yield. The prices of high-yield and high-spread assets tend to respond to changes in the credit environment.
For institutional investors interested in return-enhancing asset classes and strategies, an unconstrained corporate credit strategy could work well alongside equities and other diversified growth strategies, hedge funds and absolute-return vehicles. Alternatively, an unconstrained strategy may sit within the matching portfolio, perhaps considered as a way of outyielding short-dated liabilities.
Lisa Coleman is head of the investment-grade corporate credit team in New York and London at J.P. Morgan Asset Management.
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