Lower-Rated Bonds May Improve LDI Strategy

BBB-rated corporate bonds merit important consideration in the asset allocation of pension funds implementing liability-driven investing (LDI) strategies, Standish Mellon Asset Management contends.

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.”

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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.”

Online Advice Firms Will Be a Disruptive Force

The emergence of digital technology and increasingly connected investors has the potential to unsettle the dynamics of the financial advice industry, according to a Celent report. 

In “Automating Advice: How Online Firms Are Disrupting the Market for Online Advice,” Celent researchers suggest traditional providers of financial advice must change the way they do business or face radical disruption in client prospecting and retention efforts. Online firms have gained significant market traction in the last five years, according to the report, most notably in the domain of investment advice and passive portfolio management.

Online firms appear to be particularly well suited to deliver investment-oriented services because of the fragmentation of traditional delivery models and the adoption of passive investing strategies, which can be delivered effectively in the way of model portfolios and rebalancing algorithms. There is also the potential for disruption in the areas of personal financial management and personalized financial planning, the report says.

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Specific to retirement advice, there appears to be increasing digital competition for managed account services (see “Software Firm Wants to Disrupt DC Industry”).

Celent researchers find low-cost online providers of financial advice have a value proposition that resonates among lower-income and younger-generation investors, especially Millennials and those in Generation X. These groups still value face-to-face contact with professional service providers, but they are also more familiar with conducting important financial tasks online.

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The report suggests many traditional advice providers have responded to the online adviser threat by moving up market, targeting more affluent investors who value in-person meetings and highly individualized service. However, Celent warns this strategy may offer only temporary respite as online advice providers become more sophisticated and younger generations of investors secure more wealth.

The report also discusses a variety of ways firms can abandon this defensive crouch, mainly by building on their inherent competitive advantages that cannot necessarily be matched by inexpensive online advice. For instance, firms that specialize in holistic financial planning and highly customized investment approaches may find it easier to out-sell online advisers. Again, Celent warns that even this approach may fail in the long run as online advice models are improved by innovative digital providers.

“Traditional advisers and the financial institutions that employ them must put aside legacy practices to deliver digitized advice and, ultimately, digital relationships,” says William Trout, senior analyst with Celent’s securities and investments group. “In short, they need to take a page out the book being written by the automated providers.”

Celent also suggests there is an ongoing convergence taking place as investment services providers increasingly embrace the concepts of individualized financial planning and personal financial management. This move could challenge the success of both online and real life advisers, Celent warns.

The abstract of the report, as well as information on how to obtain a full copy, is here

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