October 2017

Are You “Active” in LDI?

Navigating Ratings Migrations in Long Credit

Michael Keough | Follow Portfolio Manager
Mayur Saigal | Follow Portfolio Manager
Darrell Watters | Follow Head of US Fundamental Fixed Income | Portfolio Manager

Key Takeaways

Rising rates and strong asset returns are fostering a more favorable environment for LDI strategies.
Long-credit reduces tracking error versus pension liabilities and can be a suitable alternative to non-corporate liability hedges.
Employing a fundamental, bottom-up research process can protect plan assets by mitigating credit quality deterioration and capitalizing on ratings upgrades.

Introduction

Many pension plans have experienced a recent recovery in funded status as a result of rising interest rates and strong asset returns. The continuation of these trends will provide pension officers the opportunity to implement liability-driven investment (LDI) strategies or progress along their glide path. Establishing and actively managing a glide path between return-seeking and liability-hedging assets is a critical step in minimizing funded status volatility and generating excess returns over pension liabilities. As plan sponsors increasingly adopt LDI strategies, it is important to consider long credit as an effective liabilities hedge, particularly given that pension obligations are valued using a corporate discount curve.

Long-duration credit can play a prominent role in reducing funded status volatility. However, plan sponsors allocating to long corporate bonds will need to consider the importance of actively navigating both the risks and the opportunities of credit ratings migrations. Long-duration corporates are asymmetrically exposed to credit downgrades, which can be particularly damaging to a plan’s funded status due to the structural mismatch in how pension liabilities and pension assets are valued. An actively managed credit portfolio emphasizing healthy corporate fundamentals can help fiduciaries preserve capital within plan assets. Moreover, fundamental research that capitalizes on credit upgrades can help offset credit quality deterioration and provide the potential for consistent risk-adjusted performance.

In what follows, we highlight the unintended drawbacks of using non-corporate instruments to hedge pension liabilities. We also quantify the magnitude of credit downgrades in the investment-grade segment of the U.S. fixed income market and discuss the risks of utilizing passive or enhanced index strategies in LDI. Most importantly, we stress why actively managed long-credit portfolios may offer a superior solution to address the needs of defined benefit (DB) plans as their funded status improves and plan sponsors rebalance from return-seeking assets to liability-hedging assets.

Long-Duration Credit: An Effective Liability Hedge as Funded Status Improves

Strong equity performance has contributed to the recent improvement in funded status for many plan sponsors, creating the opportunity to shift assets from the return-seeking portion of their portfolio into the liability-hedging segment, or to implement an LDI strategy. The prospect for higher rates driven by improving economic conditions and potentially growth-enhancing fiscal initiatives could present a favorable environment for fiduciaries to de-risk and increase exposure to liability-hedging assets. Exhibit 1 summarizes some of the most common liability-hedging tools available to plan sponsors today.

Exhibit 1: Basic Liability-Hedging Tools

Effective at Various Stages of the Glide Path

Treasury futures, nominal Treasury bonds and interest rate swaps are all valuable at various stages of the glide path. However, as a plan’s funded status improves and plan sponsors establish a larger allocation to liability-hedging assets, the use of corporate bonds becomes an essential component in mitigating portfolio tracking error versus the liability benchmark. Non-corporate instruments lack the credit-spread duration included in the liability discount rate. As a result, duration-neutral Treasury bond portfolios, for example, tend to exhibit significant tracking error versus pension liabilities, as shown in Exhibit 2.

Exhibit 2: Tracking Error versus the Bloomberg Barclays U.S. Long Corporate AA Index

Long-Duration Credit Can Reduce Tracking Error versus Liabilities

Source: Barclays POINT. Forward-Looking 12-Month Tracking Error as of 5/10/2017.
^*Custom index using Treasurys that match the key rates and overall duration of the Bloomberg Barclays U.S. Long Corporate AA index.

Long corporate credit provides an attractive alternative once funded status improves – when a greater precision in the liability hedge is required. The spread duration and higher yields on long corporate bonds can meaningfully reduce tracking error, as demonstrated in Exhibit 2. While a long corporate portfolio may offer an effective solution to minimize funded status volatility, active management of the corporate portfolio is critical in protecting plan assets from credit downgrades.

Actively Avoiding Corporate Credit Deterioration: A Crucial Step in Protecting Plan Assets

Over the last few years, there has been a sustained re-leveraging of corporate balance sheets, often resulting from debt-funded merger activity or share repurchases. Exhibit 3 demonstrates that corporate leverage, as defined by Total Debt/EBITDA, rose to 2.9x at the beginning of 2017. This is well above the 2009 high, despite a substantial rebound of earnings post-financial crisis lows. Debt issuance for the sake of shareholder-friendly activity frequently leads to credit downgrades and spread widening, which has an outsized negative impact on bond returns, particularly in the longer maturities of an issuer’s capital structure.

Exhibit 3: U.S. Investment-Grade Corporate Leverage

Rising Debt/EBITDA as Companies Re-Leverage their Balance Sheets

Source: JPMorgan as of 12/31/2016.

Moody’s migration rates quantify the long-term ratings deterioration trend in the investment-grade credit market. Over a one-year period, approximately 85% of Aa-rated issuers maintained their original rating. However, this number drops to just 46% over a five-year period, with more than 28% of issuers suffering a ratings downgrade, as shown in Exhibit 4. These trends also hold true for Aaa and A corporates. The asymmetric skew toward downgrades can be costly for DB plans that invest in high-quality, long-duration credit portfolios.

Exhibit 4: Average 5-Year Investment-Grade Rating Migration Rates (1970 – 2015)

Downgrades Prevalent in Upper Tiers, Lowest Tier Offers Opportunity to Capitalize on Upgrades

Source: Moody’s.

There is a natural tendency for investment-grade companies – as a group – to deteriorate in quality; therefore, passively managed and, to a lesser degree, enhanced index, long-credit portfolios will also naturally degenerate in quality over time. If roughly 50% of the high-quality investment-grade issuers witness credit downgrades or a withdrawal of ratings after five years, the impact on passively managed credit portfolios will be reflected through higher option-adjusted spreads and lower portfolio values. In contrast, the value of pension liabilities is immune from credit downgrades because the discount rate remains unchanged once the downgraded securities are removed from the long-credit double-A index.¹

Active managers who focus on company fundamentals can often recognize early warning indicators of potential credit downgrades and mitigate risks to plan assets. By managing corporate credit risk from a fundamental standpoint, active credit managers have the tools to navigate ratings migrations and maintain a consistent credit rating at the overall portfolio level.

Fundamental Research: The Key to Capitalizing on Credit Upgrades

Even though pension liabilities are discounted using the average yield on high-quality corporate bonds, pension officers may allow triple-B bonds in their long-credit portfolios. They do so to broaden the investable universe of cash bonds and to seek additional yield by judiciously going down the credit risk spectrum.

Hedging liabilities is the first priority for most plan sponsors that have implemented an LDI strategy. However, investors who are singularly focused on this objective may forgo the potential gains associated with credit upgrades. While a credit manager’s ability to navigate the asymmetrical risk of the fixed income markets and protect plan assets is essential, an active manager’s ability to identify issuers committed to improving credit quality can expose the portfolio to strong risk-adjusted opportunities.

Compare the magnitude of ratings upgrades versus downgrades in the Baa segment of the credit market in Exhibit 4: credit upgrades (13.9%) actually exceeded credit downgrades (12.5%) over the average five-year period, while Aa- and A-rated credits only had 2% and 8%, respectively, of issuers upgraded. This observation is consistent with our research in the credit universe, where many Baa-rated companies are strengthening their balance sheets and pursuing ratings upgrades. Opportunistically investing in credits poised for ratings upgrades as a result of improving fundamentals can provide attractive risk adjusted returns and a source of alpha for liability-hedging portfolios.

The following case studies demonstrate how an investment process grounded in fundamental credit research can add value in long-corporate liability-hedging portfolios. Such a process can uncover companies that are candidates for credit ratings upgrades and identify those at risk of a downgrade.

Sherwin-Williams (SHW): Another Merger, Another Credit Downgrade – Ratings Migrate from A to Baa

Issuers within the investment-grade chemical sector are participating in an elevated wave of merger and acquisition activity: Sherwin-Williams acquiring Valspar, Dow Chemical merging with DuPont, Bayer AG bidding for Monsanto. In each transaction, an A-rated issuer will sacrifice its credit ratings by taking advantage of low-cost debt financing in order to gain scale and reduce expenses. While these mergers have been well received by shareholders and rewarded with strong equity returns, creditors have not fared as well.

Sherwin-Williams is one of the largest paint and coatings companies worldwide. Its strong brand and extensive distribution network of over 4,100 stores provides the company a significant competitive advantage. SHW has a track record of steady organic growth, elevated margins, and consistent free cash flow. In 2016, however, SHW announced the $11 billion acquisition of Valspar – a merger intended to improve both product and geographic diversity. Prior to the merger, SHW maintained a strong balance sheet with less than 1x leverage (Debt/EBITDA) and solid A ratings. Yet the company aggressively chose to fund the entire purchase of Valspar with debt, causing leverage to spike to over 4x. This shift in financial policy, coupled with a now weaker balance sheet, resulted in Moody’s downgrading SHW’s rating four notches, from A2 to Baa3, between merger announcement and close. Since January 2016, SHW’s 30-year credit spreads have widened over 70 basis points relative to their A-rated long-corporate peers. This has resulted in a -11% relative return, which demonstrates the equity-like volatility these credit events can inject into liability-hedging portfolios.

We believe a robust fundamental research process – one that properly assessed the risks of merger activity in the sector and accurately identified management’s intentions to utilize SHW’s under-levered balance sheet to drive shareholder returns – could have prevented investment in this security. Actively managing credit risk in long-duration portfolios is crucial to avoiding ratings downgrades and ensuring the liability hedge is effective in reducing funded status volatility.

Exhibit 5: Spread of Sherwin-Williams versus Long Corporate Index

Debt-Funded Acquisition Results in Ratings Downgrade and Significant Spread Widening

Source: Janus Henderson Fixed Income.

Raymond James (RJF): Building Scale While Maintaining a Conservative Balance Sheet Leads to a Ratings Upgrade

Founded in 1962, Raymond James Financial is a leading financial services company, but is generally under-followed among credit investors. Over the last several years, RJF has strategically diversified its revenue base, favoring more stable, recurring revenues provided by its Bank and Private Client Group. The company’s management team has typically taken a conservative stance with its balance sheet and emphasized decreasing its risk profile. Priority was placed on receiving a ratings upgrade, predominately by strengthening the resiliency of its operations through scale. Yet, as a credit investor, the strategy by which scale is achieved is an important factor to consider.

Too often, in an effort to grow quickly, companies engage in expensive, debt-funded acquisitions that can increase a company’s risk profile and jeopardize credit ratings. In the case of RJF, understanding management’s values, intentions and strategy to achieve scale was essential in discerning how the company would grow its business. Through steady, deliberate actions, the company focused on organic growth and modest acquisitions that did not jeopardize its conservative leverage targets and financial risk profile.

While these improvements strengthened the issuer’s fundamentals, they were also key criteria that contributed to a ratings upgrade. In 2016, RJF issued a 30-year bond at a spread of 290 basis points. In the spring of 2017, Moody’s placed RJF on review for an upgrade from its Baa2 rating in recognition of the enhancements, and S&P raised RJF’s rating from BBB to BBB+. Since issuance, the credit spread on the long-term bond declined to 190 basis points, leading to an attractive excess return of over 8% compared to the long credit index.

In the case of RJF, navigating a change in ratings is acutely connected to not only understanding the fundamentals of a business, but also understanding and managing around management’s intentions. A keen bottom-up, fundamental approach, in combination with a forward-looking investment focus, is critical to capturing the outperformance associated with a ratings upgrade.

Exhibit 6: Spread of Raymond James Financial versus Long Corporate Index

Dedication to a Conservative Balance Sheet Leads to Ratings Upgrade and Tighter Spreads

Source: Janus Henderson Fixed Income.

Conclusion

The recent recovery in funded status and rising interest rates may provide an opportunity for plan sponsors to adopt LDI strategies or transition along their glide path. As funded status improves, corporate plan sponsors will continue to evaluate the shift from return-seeking assets to liability-hedging assets. While non-corporate instruments provide the necessary duration exposure, they often add to funded status volatility. High quality, long-corporate bonds can be a more effective solution and should play an increasingly important role in LDI; however, they come with risks that must be actively managed. Investment managers who use fundamental research can avoid downgrades while identifying companies with improving credit quality to capitalize on credit ratings upgrades. We believe that actively managed long-credit portfolios are an optimal solution to hedging pension liabilities while mitigating downside risk and uncovering attractive risk-adjusted return opportunities.

Bonds that witness credit downgrades would be included in the current month for the calculation of the average yield in discounting pension liabilities; however, the downgraded bonds would no longer be eligible for the yield calculation in subsequent months because they no longer meet the minimum credit rating criteria.