SBH Investment Summit
Fourth Quarter 2023:
Liability-Driven Investing (LDI)

Why Now May Be the Time to Increase LDI Exposure

Given attractive yields along with high funded ratios and moderate fixed income allocations by pension plans, now appears to be an opportune time for plans to consider increasing their LDI exposure. Darren Hewitson, CFA, Senior Portfolio Manager, discusses opportunities in long duration for pension and LDI investors.

 

Key Takeaways

  • The recent rise in long-term yields has been driven by increased Treasury issuance and declining demand from major investor groups like central banks, commercial banks, and foreign investors.
  • While credit spreads have been reasonably well-behaved and valuations are full, our team continues finding relative value opportunities within major sectors.
  • SBH can help design customized LDI strategies to capitalize on today’s higher yields based on each client’s unique liabilities and circumstances.

[Dan McCormack] Following the increases that we experienced in 2022, we have seen yields continue to move higher across the Treasury curve over the last few months, particularly for longer duration securities. What do you think drove us to this point and do you expect any major changes?

[Darren Hewitson] It has been about a year since we last had a discussion on a similar topic, which we did in the wake of the U.K. pension crisis in 2022 which saw a big sell-off in long-term yields. It is interesting timing for a couple of reasons. The first being that we have seen a move of similar magnitude in long duration Treasuries over the last few months. And the other thing that’s timely is that we just had the Treasury’s quarterly refunding announcement. The reason I say that’s interesting is because this is one of the things that we think precipitated the move over the last few months, that is, the prior refunding announcement that came out in August. We think that caught investors off guard and started the move higher in yields and the steepening of the yield curve.

What does that mean? It’s more long duration Treasury debt coming to market or more debt issuance. When thinking about a traditional supply-demand-type construct, it has been a supply shock to the market. We then combine that with demand erosion, which is what we have seen over the last several quarters from three large constituents of the market (central banks, commercial banks, and foreign investors) as illustrated in Exhibit 1.

Exhibit 1: Major Holders Have Reduced UST Holdings by $845 Billion Despite Continued Issuance


Year to date change in UST supply and combined Fed/bank/foreign UST holdings. Data as of 6/30/23. Source: Bloomberg.

 

Over the last decade or so, those three investor bases have comprised over 50% of the Treasury market at times. That support has declined as those investor types have pulled back. If we go back to Economics 101 of supply versus demand, there has been a supply shock and a reduction in demand. What does that do? All else equal, that pushes prices down or, in the case of fixed income, it pushes yields up, which is what we have seen.

We have seen a more resilient economy than some people expected over the last few quarters. We continue to see volatility from a number of factors (geopolitical, for example). These are some of the big factors we believe have driven this move and we do not necessarily see a big change in those coming in the near term.

[McCormack] If you put all that in a blender, where are you finding the opportunities within credit?

[Hewitson] Credit is interesting. We will continue our supply demand analysis and flip it on its head when we are looking at long duration credit. Long duration credit supply has been lower relative to expectations. That makes sense for a number of reasons as corporate Treasurers are a little less inclined to lock in these types of yields for longer terms.

We have seen supply lower than expectations. On the demand side of the market, given about a 6% yield on long duration high-quality fixed income, we’ve seen significant interest from a number of different investor types including pension funds and insurance companies, among others. Putting those two things together, we have seen the opposite to the Treasury market. This means that long duration risk premium or credit spreads have been well-behaved which has manifested in valuations in the market.

The overall corporate bond market is sitting at roughly median spread valuations over the last 10 to 12 years and the long duration markets were sitting around 10%, with zero being the tightest or the richest. Valuations are fairly full; however, we think there are significant relative value opportunities within that. That can come in different ways, maybe amongst the major sectors of the market (being Industrial, Financial, and Utility) or it could be individual industries within those sectors. We have different points on the credit or yield curve (for example, 20 year, 30 year, and 40 year maturities can all trade differently) or, of course, idiosyncratic credit risk in individual credits in the market that we think may be mispriced.

Valuations I would say on the whole look full. That supply demand dynamic could also continue for a long time, but we believe there are still opportunities within those cohorts for investors in this part of the fixed income market.

[McCormack] You work with a number of clients that utilize long duration. What do your clients think today regarding the role LDI plays in their portfolios and how can we help other investors with long duration mandates?

[Hewitson] The things that we have talked about are not going unnoticed. In our view, it is still a pretty opportune time for looking at these types of strategies or increasing allocations.

If we focus on the pension market, there are three primary factors to which we could point. One is healthy funded ratios; as a result of higher interest rates and positive risk asset returns over time, funded ratios are sitting around a hundred percent on average.

The second being that available yields of around 6% are higher than we have seen in quite some time. And then lastly, as illustrated in Exhibit 2, the average pension plan still only has about a 50% allocation to fixed income with the other 50% being in equities and other investment types.

In our view, that third factor should begin to, or continue to, increase given the first two factors that we outlined. Seems to us the prudent thing to do is to start increasing that hedge in light of that position.

Each client’s liability or set of circumstances is unique and that is something where SBH feels we can help design those appropriate strategies for long duration investors to help take advantage of those factors that we see in the market today.

Exhibit 2: Pension Asset Allocation Over Time

Milliman 2023 Corporate Pension Funding Study, April 2023.

 

Additional Resources:

Liability-Driven Investing Strategy

Taxable Fixed Income Strategies

Fixed Income Insights

 

The opinions expressed in this video are solely the opinions of Segall Bryant & Hamill or an unaffiliated third party. You should not treat any opinion in this video as specific inducement to make a particular investment or follow a particular strategy, but only as an expression of opinions. The opinions expressed in this video are based upon information considered reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this video does not constitute financial, legal, tax, or other professional advice and is not intended as a substitute for consultation with a qualified professional. The opinions and statements are subject to change without notice and Segall Bryant & Hamill is not obligated to update or correct any information in this video. For illustrative purposes only.

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