LDI Investors: Time to Bite the Low-Hanging Fruit

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1 FEATURED SOLUTION January 2017 LDI Investors: Time to Bite the Low-Hanging Fruit AUTHORS Rene Martel, FSA, CFA Executive Vice President Product Manager Last February, we highlighted a unique opportunity for corporate defined benefit plan sponsors.as we explained in The Best Time to Accumulate Long Credit Bonds May Be Now, historically wide investment grade credit spreads at the long end of the curve offered an attractive entry point for liability-driven investors to accumulate long credit bonds they had been planning to purchase down the road as part of their de-risking programs. To be sure, persistently low interest rates and, more specifically, the potential for an increase in those rates presented a challenge last year. Indeed, rising rates could have significantly detracted from returns on long duration credit bonds despite the attractive entry point from a spread perspective. Mohit Mittal Managing Director Portfolio Manager Our solution to that challenge entailed isolating the exposure to long-dated credit spreads by hedging (or mitigating) duration exposure with interest rate derivatives. This durationhedged long credit strategy was designed to benefit significantly from wide credit spreads, even in an environment where long-term interest rates would rise. While more complex in its implementation given the use of interest rate derivatives, the strategy delivered stellar results. In fact, this duration-hedged long credit portfolio strategy returned nearly 15% between 10 February 2016, when we published our article, and the end of 2016, despite a meaningful increase in long-term interest rates toward the end of the year (see Figure 1).

2 2 January 2017 Featured Solution Figure 1: Long credit and duration-hedged long credit provided strong returns For period 10 February 2016 to 31 ember 2016 Change in long credit OAS Change in 30-year Treasury yield Long credit performance Duration-hedged long credit performance -100 bps 58 bps 9.0% 14.8% Source: Barclays Live Hypothetical example for illustrative purposes only. Past performance is not a guarantee or reliable indicator of future results. Long Credit represented by Bloomberg Barclays U.S. Long Credit index, Duration-hedged long credit performance represented by 100% Bloomberg Barclays U.S. Long Credit index, 16.6% Bloomberg Barclays U.S. PAR Receiver Swap Index 10-year, 49.7% Bloomberg Barclays U.S. PAR Receiver Swap Index 30-year, +66.3% U.S. 3-month LIBOR index. It is not possible to invest directly in an unmanaged index. But market conditions have changed dramatically since last February. Long-dated investment grade credit spreads have tightened more than 100 basis points (bps) from their mid- February 2016 peak, while long-term Treasury yields have increased by a similar amount relative to their July 2016 lows (see Figure 2). Plan sponsors should factor in these significant market movements as they plan capital allocation decisions for Despite spread tightening, we believe the timing is once again ripe for long credit bonds, thanks this time to higher yields. THINGS ARE GETTING SIMPLER Setting aside the discussion of current market factors, the simplest and generally most effective strategy for corporate defined benefit (DB) plan sponsors seeking to reduce assetliability risk is to shift more assets toward long-dated credit bonds. While DB plans made heavy use of that strategy from 2008 to 2014, we have witnessed a slowdown in the progression of long credit bond allocations over the last two years. Many sponsors were concerned about the prospect of rising rates and believed that a better entry point would arise to resume the increase in LDI allocations. In the meantime, different strategies were employed in an effort to continue to reduce risk as plans waited for the low-hanging fruit to come back. Examples include duration-hedged long credit strategies, asymmetric swaption collars and even liability transfers (lump sums or annuities). While these strategies may provide some risk reduction, in our view they are not as straightforward or efficient as long credit bond allocations when it comes to managing asset-liability risk. Many involve the use of derivatives, entail significant basis risk versus discount rate methodologies, require monitoring and some amount of market timing, or are cumbersome from a time and resources standpoint. Thus, their potential risk-reduction payoff relative to the time, effort and resources invested is nowhere near that of a long credit bond investment. Figure 2: Treasury yields up, credit spreads down Yield (%) OAS (%) year Treasury yield 30-year Treasury yield Bloomberg Barclays U.S. Long Credit OAS Long-term average OAS Pre-2008 recession average OAS Source: Bloomberg and PIMCO as of 31 ember Long-term average OAS is calculated based on OAS between index inception (1990) to 31 ember Pre-2008 recession average OAS is calculated based on OAS between index inception (1990) and 31 ember 2007.

3 January 2017 Featured Solution 3 Figure 3: Long credit is the most efficient liability hedge by far Asset class Yield Expected return Tracking error to liabilities Long credit bonds 4.6% 3.9% 3.2% Long gov t bonds 2.6% 2.8% 8.2% Long-dated swaps 2.4% 2.8% 8.4% U.S. equities 2.1% 4.6% 17.0% Global equities 2.5% 5.0% 18.5% Asset class Yield/tracking error to liabilities Expected return/ tracking error to liabilities Long credit bonds Long gov t bonds Long-dated swaps U.S. equities Global equities Hypothetical example for illustrative purposes only. Past performance is not a guarantee or reliable indicator or future results. Source: Barclays Live and Bloomberg and PIMCO as of 31 ember Liability duration assumed to be 13.6 years. Long credit bonds represented by Barclays U.S. Long Credit Index. Long government bonds represented by liability-duration matching blend of 73% Barclays U.S. Long Government Index and 27% Barclays U.S. Intermediate Government Index. Long-dated swaps represented by liability-duration matching blend of Bellwether 10-Year Swaps Index and Bellwether 30-Year Swaps Index. U.S. equities represented by S&P 500 Total Return Index. Global equities represented by MSCI All Country World (ACWI) Index. Bond yields are yield-to-maturities. Equity yields are index dividend yields. It is not possible to invest directly in an unmanaged index. Expected return is an estimate of what investments may earn on average over the long term and is not a prediction or a projection of future results. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods. There is no guarantee that these returns can be realized. The good news for plan sponsors is that the recent significant increase in long-term interest rates is making long corporate bonds compelling again and offers a good entry point to pivot toward that simpler and more efficient hedge (see Figure 3). HIGH QUALITY CREDIT MARKETS REMAIN ATTRACTIVE Today s economic backdrop remains supportive for high quality credit markets such as the U.S. investment grade universe. While U.S. long credit spreads have tightened meaningfully over the last year or so, their current level (167 bps over like-duration Treasuries) continues to exceed the long-term average by about 20 bps and the pre-2008 recession average by approximately 50 bps. Above-average compensation for credit risk appears especially attractive as fundamental and technical factors remain strong for the asset class, including: lining leverage. After an uptick in corporate sector leverage in recent years as corporations took advantage of low yields and flat yield curves to issue more debt, particularly in longer maturities we expect leverage metrics to come down in future years as interest rates rise. Potential earnings repatriation. A number of the policy proposals being considered by the Trump administration should be supportive for corporate debt markets. Specifically, an earnings repatriation tax holiday has the potential to reduce corporate debt issuance by 10% to 15% in 2017 (relative to 2016) as companies may use a share of repatriated earnings to pay down debt, support capital expenditures, pursue M&A or buy back equity all of which would have been funded with debt issuance in prior years. Tax reform. Other policy proposals, such as reducing the tax deductibility of interest expense for corporations and lowering taxes on interest income, would also favor credit markets by encouraging demand and lowering supply. Foreign demand. Higher yields broadly across fixed income markets should also make long corporate bonds even more attractive for foreign investors. While the U.S. has entered a hiking cycle, central banks in Europe, the UK and Japan remain in quantitative easing (QE) mode, thereby suppressing attractive investment opportunities for investors in those regions. We expect this dynamic to further encourage foreign investors to invest in U.S. high quality credit.

4 4 January 2017 Featured Solution In sum, in 2017 we believe that long credit market technicals will remain very supportive, and fundamentals will likely continue to improve as earnings recover and the corporate sector shifts from a five-year period of releveraging to deleveraging at higher yields. While valuations have tightened significantly since our publication in February 2016, current levels still offer attractive yield and price appreciation potential for long-term investors. Sector and security selection will be instrumental in generating returns as we shift from a long period of monetary policy-driven asset price valuations to more fundamentals-based valuations, and incorporate the impact of the new administration s policies. With its deep bench of portfolio managers and analysts around the world, PIMCO is uniquely positioned to add value during this transition. This is more important than ever as forward-looking expectations of asset class beta are lower than they have been for the past five years. YES BUT Interest rates will continue to rise. While many construction workers may be comfortable working without a harness on a three-foot-high scaffold, very few would climb on a 30-foot scaffold without one. All else equal, it could be argued that a construction worker is not more likely to fall from a 30-foot scaffold than a three-foot scaffold. Nonetheless, the dramatic difference in potential severity leads to a very different attitude toward risk management. Similarly, as long-term Treasury yields rose by more than 100 bps over the last six months of 2016, the potential amount of downside risk has increased materially for DB plans, even if the sponsor s base case is for interest rates to continue to trend higher. In other words, while one may put a low probability on rates falling from here, there is more room to go down, and this could lead to a higher degree of funding ratio pain. Therefore, sound risk management principles suggest that DB investors should target a higher liability hedge ratio (relative to their target prior to the rise in rates), regardless of their view on the future path of interest rates. And long duration credit bonds should play an important role in increasing that hedge ratio. We have not hit a de-risking trigger on our glide path. A glide path strategy is an excellent de-risking tool, primarily because of two important features: First, it reduces the amount of risk when the potential reward for taking that risk becomes less significant. That is, as the plan becomes fully funded or overfunded, the sponsor and participants do not benefit as directly and as significantly from further improvement in the funding ratio. As such, it is important to reduce risk-taking if the potential reward is not as significant. Second, the glide path increases the likelihood that de-risking (i.e., purchasing of long duration bonds) will be implemented at a relatively more attractive time. Because the main driver of funding ratio improvement is likely to be rising interest rates, the glide path should naturally lead to purchasing long duration bonds after they have become cheaper. Glide path construction should balance these two important features. However, if a glide path has not been triggered after a 100 bps increase in interest rates over a six-month horizon, it may imply that its construction over-emphasized the first feature at the expense of the second. In this case, plan sponsors should revisit their triggers and consider taking advantage of the recent increase in interest rates to achieve the potential benefits of the second feature. We can t afford the reduction in expected return on assets (EROA) that would result from shifting assets from equities to long credit bonds. For a number of plan sponsors, the accounting implications of de-risking may be difficult to stomach at this particular time. Unfortunately, this additional constraint can greatly complicate efficient de-risking and prevent the plan from taking advantage of market opportunities. This ultimately becomes a feedback loop in which the investor cannot de-risk because of accounting considerations. Yet because the sponsor does not take advantage of market opportunities, it cannot get to a position where the accounting implications are less significant.

5 January 2017 Featured Solution 5 It need not be that way, however. These plan sponsors can still take advantage of today s higher interest rates by liquidating a portion of their physical equity holdings and purchasing a portfolio comprised of long credit and long government bonds. Then, the equity exposure forgone can be reinstated by implementing an equity overlay on top of the long duration bond portfolio. As sponsors effectively maintain their equity exposure, there should be no adverse EROA implications, all else equal. In fact, one could argue that this strategy should have a positive impact on EROA as the invested dollars are now exposed to two different betas (long bonds and equity). (For more on this strategy, see our August 2016 paper, Targets and Tactics: Overcoming Lower Return Expectations. ) TAKE A BITE Keep it simple. Whenever possible, that is good advice for life and for investing. The opportunity is once again ripe for liability-driven investors to incorporate more long credit bonds into their de-risking plans. Of course, no investment strategy is without risk, and there may be significant volatility resulting from Trumponomics or global developments. Still, we believe it s time to bite.

6 Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchangetraded may be less liquid than exchange-traded instruments. Hypothetical examples are for illustrative purposes only. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. Glide path for defined benefit is a de-risking strategy based on a function of plan funded status. As plan funded status improves, clients may be interested in reducing their plan funded status volatility by shifting out of risk assets and into liability-hedging fixed income. Expected return is an estimate of what investments may earn on average over the long term and is not a prediction or a projection of future results. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods. There is no guarantee that these returns can be realized. Duration Hedge Ratio = asset duration exposure / liability duration exposure. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. 2017, PIMCO. Newport Beach Headquarters 650 Newport Center Drive Newport Beach, CA Hong Kong London Milan Munich New York Rio de Janeiro Singapore Sydney Tokyo Toronto Zurich pimco.com blog.pimco.com CMR