Does equity hedge spreads? If so, is it useful for LDI?

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1 By: John Osborn, CFA, Director, Consulting JULY 2012 Does equity hedge spreads? If so, is it useful for LDI? Issue: Many defined benefit pension plans are seeking to implement liability -driven investing (LDI) programs by matching the durations and credit exposures of their asset portfolios to the durations and credit exposures of their liabilities. Does equity exposure help to this end? Response: As Gannon stated in 2010, equities responsiveness to interest rate changes is unreliable in the context of a liability-hedging program, and therefore the duration of the equities is best ignored in building LDI programs. 1 However, while equities are not a reliable hedge against interest rate movements, they have historically provided an effective hedge against movements in the credit spread (a component of liability discount rates albeit a secondary component to duration). In particular, equities have tended to perform well when spreads are falling and liabilities are rising. We believe it is appropriate to consider this when determining the government/credit mix in the design of an LDI program. It is appropriate to consider equity exposure when determining the government/credit mix in the design of an LDI program Background We want our hedging assets and our liabilities to have similar characteristics, so that we can have higher confidence in each being sensitive to the same market forces and therefore moving together. Funding and accounting liabilities are both valued by use of a high-quality corporate bond yield curve. Corporate yields can be thought of as having a pure interest rate component and a corporate spread component. The interest rate component is commonly represented by Treasury or government yields. Corporate spreads are commonly represented by the additional yield on corporate bonds in excess of Treasuries. Gannon examined whether equities are 1 See Does equity have duration? And if so, is it useful for LDI? Jim Gannon, Russell Research, June Russell Inv estments // Does equity hedge spreads? If so, is it useful for LDI? Frank Russell Company owns the Russell trademarks used in this material. See Important inf ormation f or details.

2 sensitive to the same market forces that move the pure interest rate component, and in this note we will examine whether equities are sensitive to the spread component. For purposes of this study, we use the Russell 3000 Index to represent U.S. equities, and a combination of the Russell Global ex-u.s. and MSCI ACWI ex-u.s. indexes 2 to represent non-u.s. equities. We calculate spread returns as the difference between the returns on the Barclays Long Corporate and Barclays Long Treasury indexes. 3 CORRELATION ANALYSIS The most obvious analysis involves measuring the correlations between our equity return series and our spread return series. These correlations are shown in Table 1. Note that we have examined various holding periods: from one month to 36 months for U.S. equities, and from one month to 24 months for non-u.s. equities. For 12-month and shorter holding periods, there is reasonable evidence that positive co-movement between equity and spread returns does indeed exist, with correlations in the 0.4 to 0.7 range. However, for holding periods longer than 12 months, co-movement becomes very unstable, and we see zero and negative correlations. While periods of one to 12 months are commonly used in measuring investment performance, using longer holding periods is perhaps more important. IRS funding regulations allow yields to be smoothed over 24- month periods, and the goals of LDI programs are clearly longer-term in nature. Table 1 Horizon (months) U.S. equities Correlation Number of nonoverlapping periods Non-U.S. equities Correlation Number of nonoverlapping periods There seems to be no clear, consistent correlation pattern that holds over various time horizons. Analysis from January 1988 through March US Equities = Russell 3000Index / Non-US Equities = Russell Global ex-u.s. and MSCI ACWI ex-u.s. indexes 2 To verify the surprisingly negative correlations we see between equity and spread returns for 24-month holding periods, Table 2 shows returns for all 24-month nonoverlapping periods ending March 31. In most of the periods, we indeed see equity and spread returns with the opposite sign. 2 Russell Global ex-u.s. Index from its inception of 7/1/1996 to 3/31/2012 and MSCI ACWI ex-u.s. Index for 1/1/1988 to 6/30/ These indexes have different and varying durations over time, but the results shown in Table 1 hold even when we set the Treasury duration equal to the Corporate duration by combining intermediate and long indexes. Russell Inv estments // Does equity hedge spreads? If so, is it useful for LDI? / p 2

3 Table 2 24 months ending U.S. equities return Spread return 3/30/ % -6.6% 3/31/ % 11.0% 3/31/ % -11.5% 3/31/ % -0.9% 3/31/ % 0.6% 3/29/ % 3.7% 3/31/ % -6.7% 3/31/ % -1.1% 3/29/ % 0.4% 3/31/ % -3.0% 3/31/ % 1.6% 3/30/ % -0.5% 3/31/ % 8.4% 3/31/ % -10.9% 3/30/ % 9.5% 3/31/ % 0.2% 3/31/ % -4.0% 3/31/ % 4.9% 3/31/ % -0.1% 3/29/ % -1.8% US Equities = Russell 3000Index / Non-US Equities = Russell Global ex-u.s. linked to MSCI ACWI ex-u.s. indexes There seems to be no clear, consistent pattern or relationship that holds over all of the various time horizons. WHEN DO WE WANT A POSITIVE CORRELATION BETWEEN EQUITY AND CREDIT RETURNS? The primary purpose of an LDI program is to protect against a defined benefit pension plan s decline in funded status when its liabilities are increasing. The plan seeks to achieve this protection by holding assets that rise in value at the same time that liabilities increase. In this Russell practice note, we are less interested in periods of decreasing liabilities. With that in mind, we have focused on periods in which spread returns were positive i.e., when spreads themselves were declining. These periods put upward pressure on liabilities and therefore are the periods when ideally we would want equities to rise. We want equities to rise when spreads are falling Russell Inv estments // Does equity hedge spreads? If so, is it useful for LDI? / p 3

4 In Chart 1, the line graph shows the cumulative value (growth of a dollar) for spread returns, and we highlight the five periods of greatest concern when spread returns are positive and putting upward pressure on liabilities. We then state the cumulative Russell 3000 returns coinciding with these periods. In all five periods, U.S. equity returns are positive, and meaningfully so. We get a similar picture for non-u.s. equity returns. So, at least historically, equities have provided protection from declining spreads when it was needed most, even though the relationship at other times has been unstable. This makes sense from an economic perspective. After the bottom of an economic cycle, when the outlook for corporate profits improves and that for risk declines, we would expect equities to have positive returns and corporate spreads to decline. This has implications for the structure of a liability-focused fixed income portfolio. As Gannon noted, equities are not useful in hedging interest rate duration. The overall hedge ratio is overwhelmingly driven by the exposure to fixed income and the duration of that fixed income. However, the relationship noted above between equity returns and the credit spread (particularly when that spread is falling) can be a useful consideration when determining the government/credit mix in the design of an LDI program. Chart 1: Credit spread return Growth of $ % +74% +15% % cumulative returns on Russell 3000 Index shown during periods of declining spreads +58% +67% Equities have historically provided protection from declining spreads when it was needed most 0.65 Credit Return Cumulative Index As of March 31, 2012 In a 2011 Russell Research paper, 4 Jaugietis et al. argued that credit exposure... becomes progressively more important as allocations to fixed income increase. In implementing its discretionary LDI programs, Russell s model LDI portfolio has a relatively high government exposure when the allocation to equities is high, and a higher credit exposure when the allocation to equities is low. This is consistent with our conclusion that an allocation to equity does provide exposure to the credit component of liability discount rates in periods when spreads are declining, which is when credit exposure would be most beneficial. 4 See Jaugietis, Martin, Michael Thomas and Jim, Gannon: LDI benchmarking: When does the basis risk of an LDI hedge begin to matter? Russell Research, September Russell Inv estments // Does equity hedge spreads? If so, is it useful for LDI? / p 4

5 For more information: Call Russell Investments at or visit russellinve stments.com/institutional Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon w ithout obtaining specific legal, tax, and investment advice from a licensed professional. These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of the document. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As w ith any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Liability Driven Investment (LDI) strategies contain certain risks that prospective investors should evaluate and understand prior to making a decision to invest. These risks may include, but are not limited to; interest rate risk, counter party risk, liquidity risk and leverage risk. Interest rate risk is the possibility of a reduction in the value of a security, especially a bond or swap, resulting from a rise in interest rates. Counter party risk is the risk that either the principal or an unrecognized gain is not paid by the counter party of a security or swap. Liquidity risk is the risk that a security or swap cannot be purchased or sold at the time and amount desired. Leverage is deliberately used by the fund to create a highly interest rate sensitive portfolio. Leverage risk means that the portfolio w ill lose more in the event of rising interest rates than it would otherwise with a portfolio of physical bonds w ith similar characteristics. Russell Investments ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments management. Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Rus sell Company. The members of the Russell Investments group of companies are not affiliated in any manner w ith Frank Russell Company or any entity operating under the FTSE RUSSELL brand. Copyright Russell Investments Group, LLC. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form w ithout prior written permission from Russell Investments. It is delivered on an "as is" basis w ithout warranty. First used: July 2012 (reviewed September 2014 for continued use ; disclosure revision: July 2016) USI Russell Inv estments // Does equity hedge spreads? If so, is it useful for LDI? / p 5