BBB-rated
corporate credits may provide diversification, incrementally improved returns
and other benefits to U.S. corporate defined benefit (DB) plans that typically
invest in A and higher-rated securities in their LDI strategies, according to a
white paper from Standish Mellon Asset Management Company LLC, fixed income
specialist for BNY Mellon.
“BBBs
are still investment-grade securities, for those concerned about credit
quality,” Andrew Catalan, managing director and senior portfolio manager for
Standish in Boston, and an author of the report, tells PLANSPONSOR. “As you
move down the rating scale, the increase in the spread over Treasuries, or
overall yield, is itself enticing, but we recognize there is concern about
additional risk,” he says. “If you can select BBBs by analyzing the company and
coming up with the conclusion the investments will remain investment grade or
even be upgraded, you have a chance to harvest the returns which will be higher
now than that of higher rated corporate bonds.”
When
considering how to best meet or exceed the liability return, DB plan sponsors
recognize that the liability discount rate is developed by using AA-rated bonds
for accounting purposes or A to AAA for pension funding and other statutory
purposes under the Employee Retirement Income Security Act (ERISA). Catalan
explains that plan sponsors have the frame-of-mind that since AA is used to
discount liabilities, their assets should be in AA, but Standish finds BBBs
correlation to A-rated or AA-rated bonds is fairly high. “So, plan sponsors are
not reducing their hedge against risk by investing in BBBs,” he says.
According to the
white paper, Standish did an analysis assuming the Barclays Long Corporate
Index and its various quality sub-components (A, AA, etc.) are proxies for
liability discount rates. It then isolated the impact of different durations
across these indices by using excess returns. It found the correlation between
the Long BBB Corporate Index and the Long A to AAA and Long AA indices has been
94% and 88%, respectively, over the past twenty-five years. More importantly, the
Long Corporate Index, which comprises 47% BBBs, is very highly correlated with
both the Long A to AAA and Long AA indices with correlations of 99% and 94%,
respectively.
One
of the reasons for the high correlation, Catalan says, is that a lot of BBBs
have long duration. DB plan sponsors are increasingly turning to longer
duration fixed income instruments for their LDI strategies (see “Mulling a Graceful Glide As Funded Status Rises”). “If plan sponsors restricted
themselves to just A- or better-rated bonds, that is only about half the
universe of long corporate bonds—which is not sufficient to meet pension plans’
demand for longer duration vehicles. They are missing about half of the
universe,” he notes.
Catalan
explains that the down economy and slow economic growth has resulted in the deterioration
of credit quality for lots of companies, expanding the universe of BBBs, so
BBBs offer more diversity than they did years ago.
According
to the paper, the top ten AA-rated companies represent 83% of the AA universe
as of the end of June per data from Barclays. As the paper notes, “it would not
be prudent to hedge the liabilities with a portfolio that is highly
concentrated in a few credits.”
Catalan
adds that BBB-rated companies will try harder not to be downgraded and to
remain investment-grade than higher-rated companies, so they will be more
disciplined. He notes that higher-rated companies are pressured to return more
money to shareholders. BBB-rated companies tend to allocate less of their cash
than A-rated companies to share buybacks and dividends, which may result in
more cash debt payments and reinvestment in the company, with the potential to
improve the firm’s ability to meet future debt payments, the paper says.
More reasons pension
funds should consider BBB-rated corporate bonds can be found in Standish’s
white paper, “To BBB or not to BBB, that is the LDI Question.”