LDI themes: The case for intermediate credit

Traditionally, long corporate exposure has been the instrument of choice for pension plans, given its capital efficient nature (duration exposure per $ of assets) in hedging the overall duration target for the plan, particularly for underfunded plans or plans with a larger allocation to risk assets. As plans have become better funded and more mature, and valuations at the front-end of the yield curve have improved, we believe there could be potential for intermediate credit to provide both structural and tactical benefits to a corporate pension plan.

A new market environment

Higher interest rates have created an attractive entry point for liability hedging assets. This is particularly apparent at the front-end of the curve, where historically low term premia* is drawing investors towards the shorter or intermediate part of the curve.

This builds an increasingly compelling case for intermediate credit. As of 3/31/2023, the yield on the Bloomberg Long Corporate Index was 5.29% compared to 5.09% on the Bloomberg Intermediate Corporate Index, a difference of just 20bps. This compares to 3.10% yield for Long Corporate and 1.81% for Intermediate Corporate at the end of 2021 (12/31/2021), a difference of 129bps, highlighting the attractiveness of intermediate credit in the current market regime. Higher yields in general could also continue to bring more demand for fixed income and highly rated corporate credit risk.

*Source: Looking at 2s30s and 5s30s yield difference 1yr average compared to 10yr average as of 3/31/2023.

Time series of intermediate vs. long credit yields

The structural case

There is also a structural argument for intermediate credit, to potentially better match exposure to the liability across different maturity buckets than solely using long duration corporate bonds.

We have seen a steady increase in average LDI allocations since 2009, with allocations increasing from an average of 37.1% in 2009 to an expected 52% on average in 2022*.

*Source: BlackRock, S&P Capital IQ as of 12/31/2021 Top 100 Corporate Pension Plans by size. BlackRock estimate for 2022 based on average asset allocation changes of BlackRock’s U.S. Corporate plan discretionary clients. Estimates are based on assumptions and there is no guarantee that they will be achieved.

This means that more pension assets are finding their way into fixed income investments, improving levels of available capital, and allowing plans to have more flexibility and targeted exposure by using both intermediate and long duration credit as building blocks. Adding intermediate credit could help plans that are looking to better match their key rate duration bucket exposure across the curve.

This could be particularly applicable for plans with higher fixed income allocations and frozen pension liabilities where the duration rolldown has resulted in a lower overall duration over time.

Additionally, plans that have a cash balance component in their liability modelling typically have a shorter overall plan duration which could result in the need to add shorter duration asset classes, implemented by including both intermediate government and intermediate corporate exposure.

A more custom allocation

Intermediate duration corporate exposure can be paired with other capital efficient investments, to build a custom allocation targeting overall duration, credit spread, and key rate duration hedging for a plan.

*There is no guarantee that these investment beliefs will work under all market conditions or are suitable for all investors. Each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. There is no guarantee that this will contribute to a positive outcome.

How Intermediate Credit Assets Contribute to KRD hedging

In this example, we create a more diversified* portfolio by adding intermediate credit exposure and government bond exposure alongside the traditional long corporate and long government allocation. This could seek to improve the overall interest rate hedge ratio and key rate duration matching, in addition to adding diversification to the portfolio.

*Diversification does not assure a profit and may not protect against loss.

Looking ahead

Each pension plan is in a unique place with respect to their funded status, fixed income capital, and liability duration, among other considerations. Thematically, as both pension funding and market yields have shifted, this is leading many plan sponsors to re-evaluate their hedging exposures to ensure that they are aligned with their risk and return objectives.

Outside the scope of this paper, a potential next evolution of the intermediate spread conversation could span opportunities for intermediate spread exposure outside of the traditional corporate allocation. As plans mature and look to implement a more custom LDI investment solution, it’s time to re-evaluate the place for intermediate exposure within the toolkit.