SBH Investment Summit:
Liability-Driven Investing (LDI)

[Dan McCormack] Hello, everyone, and welcome to another session of our Investment Summit. My name is Dan McCormack and I’m a member of our consultant and client relationship team. In this session, our topic is related to liability-driven investing for institutional investors, but more specifically, longer duration assets and that part of the market. Joining me for this discussion is Darren Hewitson. Darren is a Portfolio Manager for our long duration portfolios and is an expert on this part of the market. Darren let’s start by talking about the UK gilt pension crisis which occurred at the end of September, and it spooked the market and investors, but only for about a week because of government intervention. Is that fully in the rear-view mirror or could that be an issue for investors again globally?

[Darren Hewitson] Hi, Dan. Thank you for the introduction. Interesting place to start. I think the first order of business is maybe a quick recap on what happened in the UK. And as you mentioned, the context here is specific mostly to defined benefit or DB pension plans. We do see some structural differences between the UK and the U.S. markets. So, DB plans in the UK are firstly much larger in relation to the overall size of the capital markets. That increases their relative importance, if you will, but also means that the use of derivatives and leverage are more prevalent in order to attain the duration exposures that these plans are looking for. So, the UK government, as we’re probably all aware now announced fiscal stimulus plans at a time of already double-digit inflation, and this puts significant pressure on the gilt market and long-dated gilts in particular. Also, therefore the derivative contracts tied to those assets. That then required a selling not only of gilts but also other assets to meet margin calls that were widespread on those derivative contracts as a result of those mark to market moves. As you mentioned, the next thing that happened was the Bank of England then stepped in to tame markets or stem that selloff, and that gave a window for some of these exposures to be unwound and capital to be replenished. Now, the effects reach beyond the UK for a couple of reasons. First is just the inherent linkage of global capital markets, and secondly as foreign assets held directly by UK pension funds, and that included U.S. dollar denominated fixed income securities. So, to answer your question, it’s hard to say with finality that it’s in the rear-view mirror. Again, we do believe the structure of the U.S. market is a little different. That said, leverage can cause these rapid moves even in risk-free assets as we saw, and few asset classes are immune to that type of distortion. We have seen large price swings and challenged liquidity in 2022. So, while we don’t see imminent red flags, and again, we think there are structural differences, we can’t completely dismiss the tail risk that a similar type of event could happen, either domestically or somewhere else in the world.

[McCormack] You mentioned the usage of a derivative-based strategy by those investors in the UK. Segall Bryant & Hamill uses a cash bond portfolio versus a derivative-based approach which you just described. How do you view the benefits of one versus the other strategy?

[Hewitson] I’ll start with derivatives. The main benefit of derivatives is that they allow for a significant or large amount of notional exposure with relatively low or small amount of committed capital. And what that does is it frees up additional capital either for other corporate purposes or for different return-seeking investments. Now the linkage of course there is the leverage, and some of these contracts may be levered up to 5, 10, 20 times. And as we’ve talked about in our last discussion is that can move against you very quickly. So, as you said, at SBH, we focus exclusively on cash bond strategies, so you don’t have this leverage issue. The tradeoff is it’s more capital-intensive because you’re effectively buying every dollar of exposure that you’re looking to have on your balance sheet. Specific to LDI investing as we’re talking about today, another benefit of cash portfolios is that we believe they serve to significantly better track the discount rates that they’re used to value pension liabilities because those valuations are driven by yields on high-quality corporate bonds.

[McCormack] Let’s talk about the current environment. Tell us your thoughts about current and future yields, the Federal Reserve (Fed), and the opportunity and risks as you see it for longer dated bonds.

[Hewitson] I’ll start with the Fed, and I won’t spend much time on that topic because that’s a discussion all in and of itself. I will say we’re probably near the end of the hiking cycle than the start, at least in terms of magnitude. That doesn’t have as direct an impact on LDI. Obviously, we’re focused more on the longer end of the yield curve, which is a little more removed from overnight rates that the Fed sets. So, opportunities and risks, you mentioned. Long duration, high-quality corporate yields are at levels we really haven’t seen since the Great Financial Crisis in 2008 and 2009. We think there’s definitely opportunity for incremental investment there. We’ve seen a modest widening of credit spreads in 2022 which increases those yields. Spreads have been very well behaved and there hasn’t been a large selloff. Now, in a traditional sense, you mentioned risk, Dan, that might be seen as a risk because if the Fed pushes us into an economic slowdown, all else equal you’d expect those risk premium or credit spreads to widen. Now for LDI investors, this can actually be a positive. The typical pension fund out there is under-hedged. And what that means is they can actually benefit from those increasing yields as again, all else equal, they would push down the value of liabilities more so than the value of invested assets.

[McCormack] Given that as a backdrop, do you think institutional investors and specifically corporate pension plans should consider increasing their allocation to LDI mandates as a result of these higher yields today?

[Hewitson] Absolutely. I mean, one of the things we’re seeing across the markets after these moves in 2022 are more attractive yields without having to reach and take on a high degree of risk. For LDI, we really think we’re in a sweet spot here. And the other part of the equation we haven’t discussed yet is funded ratios of pension plans. So alongside yield opportunities, average pension plan is very well funded, actually over a hundred percent on average. However, they’re still significantly under-hedged. And what means to us is it makes sense to have a glide path or an approach toward de-risking in the environment that we currently see. Now that doesn’t mean moving from zero to a hundred percent overnight. It doesn’t have to be that extreme, but we think moving in that direction seems prudent. And if we look at the two sides of the coin, if yields fall from here, the plan would then be better hedged relative to liabilities and if yields rise, there may be an opportunity cost if you didn’t bottom tick the market. But as I mentioned, the overall funded picture can actually improve. So, outside of those sort of technical dynamics, being able to earn 5% to 6% yields across the yield curve in the current environment makes it much easier for pension plans to hit the required returns they’re looking for.

[McCormack] So related to the higher yields that you just mentioned and moving beyond, say, corporate pension plans to more institutional investors more broadly, could you envision a possible increase to core, core plus fixed income allocations as well?

[Hewitson] Absolutely. I mean, the yields offered now again are relative to risk are significant compared to what we’ve seen for a lot of the last decade. It’s an interesting discussion even specific to DB plans because as I mentioned, a glide path to de-risking doesn’t have to mean immunizing in one step. So the first step may be to establish a little more duration or interest rate exposure through more traditional type vehicles, as you mentioned. Broad market strategies are a great way to do that, to either start or continue that transition. And given the available opportunities, they can also be sources of incremental return. So, we think core, core plus, even high-yield strategies, even within a DB plan context, absolutely have a place in an asset allocation and even more so for a sponsor looking to hedge that funded status risk on the margin.

[McCormack] Along those lines, as you mentioned funding, we at Segall Bryant & Hamill have seen greater interest in long-duration credit. Why does credit make more sense versus Treasuries today? And maybe talk a little bit about the pros and cons.

[Hewitson] The two main attributes of credit that we’ve talked about are firstly the enhanced yield and secondly, the tracking value relative to liabilities. Those are really the two things that stand out for credit. There are also issuers and securities in the long end of the yield curve where really to take advantage of market inefficiencies that we think can help the return proposition. Now, we contrast that to Treasuries. Treasuries offer duration with lower transaction costs, at least in most market environments. That liquidity isn’t quite as deep as it once was, and you do sacrifice both the yield and some of that tracking benefit to be more heavily invested in Treasures. An interesting dynamic we’ve seen over the last, again decade or so, is that we’ve found Treasuries and even Treasury STRIPS have been almost necessary to obtain the required duration the plan sponsors are looking for. Now, the movement upwards we’ve seen in yield has decreased the average liability duration. And what that means is that we can actually use corporate credit more extensively and therefore be more effective in actually matching the asset and liability sides of the balance sheet. So, you may give up a little liquidity in corporate bonds. But in our view, if you focus on high-quality securities, and remember ultimately that LDI is a long-term risk mitigation strategy, we think the premium you can earn in the current market environment for taking on those risks makes a lot of sense over time.

[McCormack] Excellent info, Darren. We’ll wrap it here. I appreciate everyone’s time today and please feel free to reach out to any of us for additional information. Thank you.