Calvin: Hi Joy and Angela – A pension client called asking how best to incorporate enhanced credit in their LDI strategy. Do you have time to catch up?
Joy: Yes, let’s do it!
[Clips of Joy and Calvin grabbing coffee and heading to a conference room]
Calvin: So, the funded status of corporate pensions have reached the highest point since the financial crisis. As plans consider the next stage of risk management, they’re asking how their asset allocations should evolve. What do you think?
Joy: Many pension plans have the model that one part of the portfolio is allocated to liability driven investing (LDI) and the other part of the portfolio is designed to drive growth. Over the last few years, we have been working with plans to think in a less binary way; with thoughtful design, there are certain credit assets which can be considered as both a part of the hedging portfolio and offer some diverse sources of growth. What we refer to as enhanced credit asset classes are debt instruments which may offer routine coupon or loan repayments and exposure to credit beta. Since high quality credit spreads are a part of what drives the liability measurement, you can see how these types of instruments can play double duty.
Angela: Yes, the enhanced credit asset classes include securitized, high yield and private debt such as private credit, real estate debt and infrastructure debt. They usually come with excess yield and provide diversification to the portfolio.
Here we show the expected return and risk of a variety of asset classes based on our Capital Market Assumptions. To highlight a few noteworthy comparisons: with rates being higher, high yield bonds are expected to generate comparable expected returns as US Equities with much lower volatility. Private debt like private credit and Real Estate Mezz Debt may offer even higher expected returns. We highlighted the enhanced credit asset classes on the risk-adjusted return chart on the right. There are a lot of assets to choose from, and they rank favorably in terms of asset efficiency.
In addition to offering potentially competitive expected returns, it’s effective to diversify the equity risks in the portfolio. For example, the correlation between US Equity and Infrastructure Debt is only 0.4.
Joy: Angela mentioned the diversification benefit to the growth portfolio. This is also important for the liability hedging portfolio, especially for large plans which may have concerns about concentration risk and investment grade supply and demand.
With these pressures, it is useful to obtain credit beta from a broad array of sources. Enhanced credit assets could deliver differentiated credit spread exposure.
Calvin: That sounds very attractive, what are the implementation considerations from an asset-liability management perspective?
Joy: Look at LDI hedging goals and enhanced credit assets in an integrated manner. It is important to consider how well hedged the plan is in the event of yield curve steepening or flattening, especially given recent rate volatility.
Certain of these enhanced credit strategies deliver duration to the portfolio which support key rate duration hedging. Specifically, fixed rate instruments like mortgages, Real Estate Debt or Infrastructure Debt can provide relevant rate exposure at the short to intermediate part of the curve while contributing yield and diversification.
Calvin: How do you achieve a high degree of liability hedging, assuming the enhanced credit asset classes would take capital away from traditional long duration assets?
Angela: Well, capital efficient instruments like STRIPs and derivates can support the interest rate hedging objective while freeing up capital for these credit strategies and we created a case study to illustrate exactly that.
[Top down shot of Slide 6]
The illustrative pension plan is 104% funded with a roughly 60/40 split, 60% to liability hedging and around 40% to growth. If you compare it with Portfolio 4, where we pair enhanced credit assets with a capital efficient LDI strategy, we are able increase expected returns by 50bps, while decreasing surplus risk by over 1%. We have also included two intermediate steps to show the increase in portfolio efficiency by incorporating private and public debt incrementally.
Calvin: That’s interesting. What are the considerations investors need to be mindful of when using these strategies?
Joy: With the use of synthetic instruments comes the need for managing collateral, so the plan will not become a forced seller of its growth assets in times of stress. By modeling stress events which may constrain liquidity, the LDI manager can estimate minimum levels of cash and marginable instruments which may be needed to support the leverage in the portfolio. Specifically for plans investing in private assets, cash needs of the synthetic rate overlay must be considered alongside potential capital calls and ongoing benefit payments. This kind of scenario analysis can inform pacing and balancing illiquid exposure with more liquid credit assets.
Calvin: Sounds like enhanced credit is a great value-add in a corporate pension portfolio. It could help with both liability hedging and growth. Thanks for sharing! Let’s see how we can help clients better manage their plans with these strategies.
Joy: Absolutely! If you're interested in exploring how enhanced credit strategies can optimize your client’s portfolio, feel free to reach out to us!
Clients provide data to BlackRock regarding their existing portfolios. The case study and screenshots in this material are for illustrative purposes only and are intended to describe BlackRock’s capabilities. Actual account outcomes may vary.
THE INFORMATION CONTAINED HEREIN MAY BE PROPRIETARY IN NATURE AND MAY NOT BE REPRODUCED, COPIED OR DISTRIBUTED WITHOUT THE PRIOR CONSENT OF BLACKROCK, INC. (“BLACKROCK”). These materials are not an advertisement and are not intended for public use or dissemination.
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. You should consult your tax or legal advisor regarding such matters.
This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of yields or returns, and proposed or expected portfolio composition. No representation is made that the performance presented will be achieved by any asset allocation or investment, or that every assumption made in achieving, calculating or presenting either the forward-looking information or the historical performance information herein has been considered or stated in preparing this material. Any changes to assumptions that may have been made in preparing this material could have a material impact on the investment returns that are presented herein by way of example.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offeror solicitation to buy or sell any securities or to adopt any investment strategy. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any of these views will come to pass. BlackRock does not guarantee the suitability or potential value of any particular investment. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not indicative of future results.
Investing involves risk, including possible loss of principal.
Equity and fixed income characteristics and allocations are for informational purposes only. Such characteristics and allocations are not intended to be predictions or projections of any portfolio's performance. Neither asset allocation nor diversification can ensure profit or prevent loss.
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally backed by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investors will, at times, incur a tax liability. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.
Aladdin Portfolio Risk Analysis: Charts and graphs provided herein are for illustrative purposes only. Neither BlackRock nor the Aladdin portfolio risk model can predict a portfolio's risk of loss due to, among other things, changing market conditions or other unanticipated circumstances. The Aladdin portfolio risk model is based purely on assumptions using available data and any of its predictions are subject to change. For BlackRock products, data about the specific underlying holdings are used when applying the Aladdin risk model. For third party funds, BlackRock uses underlying holdings, or in certain cases, determines appropriate proxies for relevant holdings using a combination of Morningstar and other publicly available data sources. Product specific inputs are typically based on the latest disclosed data, which may be lagged.
Risks associated with Private Markets: Investments in private markets are typically illiquid and investors seeking to redeem their holdings can experience significant delays and fluctuations in value. Direct co-investing can involve risks, including but not limited to individual company risk, availability of investments, risk of loss, illiquidity, no near-term cash flow, lack of diversification, key personnel risk, leverage risk, asset valuation risks, political and market risks, tax risks and currency risks.
Risks Associated with Private Equity: Private equity investments are speculative and involve a high degree of risk. An investor could lose all or a substantial amount of his or her investment. Interests in private equity investments are illiquid and there is no secondary market nor is one expected to develop for interests in such investments or any fund offered or sponsored; there are also significant restrictions on transferring private equity investments. Private equity investments experience volatile performance and private equity funds are often concentrated and lack diversification and regulatory oversight. Private equity funds have high fees and expenses (including “carried interest”) that will reduce such investments’ returns and a private equity investment or a fund offered or sponsored may invest in other funds which themselves charge management fees and carried interest (typically, 20% of the net profits generated by the fund and paid to the manager). A private equity investor has an ongoing financial commitment to make contributions to such funds, is subject to severe consequences in cases of default and may have to recontribute distributions to private equity investments. Investors in certain jurisdictions and in private equity funds generally may be subject to pass-through tax treatment on their investment. This may result in an investor incurring tax liabilities during a year in which the investor does not receive a distribution of any cash from the fund.
Additional Private Equity Risks:
Limited Regulatory Oversight: Since private equity funds are typically private investments, they do not face the same oversight and scrutiny from financial regulatory entities such as the Securities and Exchange Commission (“SEC”) and are not subject to the same regulatory requirements as regulated investment companies, (i.e., open-end or closed-end mutual funds) including requirements for such entities to provide certain periodic pricing and valuation information to investors. Private equity offering documents are not reviewed or approved by the SEC or any US state securities administrator or any other regulatory body. Also, managers may not be required by law or regulation to supply investors with their portfolio holdings, pricing, or valuation information. Strategy Risk: Many private equity funds employ a single investment strategy. Thus, a private equity funds may be subject to strategy risk, associated with the failure or deterioration of an entire strategy. Use of Leverage and Other Speculative Investment Practices: Since many private equity fund managers use leverage and speculative investment strategies such as options, investors should be aware of the potential risks. When used prudently and for the purpose of risk reduction, these instruments can add value to a portfolio. However, when leverage is used excessively and the market goes down, a portfolio can suffer tremendously. When options are used to speculate (i.e., buy calls, short puts), a portfolio’s returns can suffer and the risk of the portfolio can increase. Valuations: Further there have been a number of high- profile instances where private equity fund managers have mispriced portfolios, either as an act of fraud or negligence. Limited Liquidity: Investors in private equity funds have limited rights to transfer their investments. In addition, since private equity funds are not listed on any exchange, it is not expected that there will be a secondary market for them. Repurchases may be available, but only on a limited basis. A private equity fund's manager may deny a request to transfer.
Risks Associated with Private Credit
Risks associated with an investment in a private credit strategy (the Strategy) include, but are not limited to, the following: (i) the Strategy is speculative and its investments are subject to a risk of total loss, (ii) the performance of the Strategy may be volatile, (iii) the general partner of the Strategy will retain ultimate authority over the Strategy’s assets and investment decisions, (iv) there are restrictions on the ability of investors to withdraw capital and on the transferability of investor ownership interests in the Strategy, (v) the fees and expenses of the Strategy may offset any profits of the Strategy, (vi) investing the Strategy may involve complex tax structures and delays in distributing important tax information, (vii) the Strategy is not subject to the same regulatory requirements as mutual funds. Investors should also be aware that as a global provider of investment management, risk management and advisory services to institutional and retail clients, BlackRock engages in a broad spectrum of activities. Although the relationships and activities of BlackRock may help offer attractive opportunities and service to the Strategy, such relationships and activities create certain inherent conflicts of interest between BlackRock and the Strategy and/or the Strategy’s investors. Further risks associated with the Strategy include, but are not limited to, the following: i.) Credit & Interest Rate risk ii.) Risks associated with high-yield, non-investment-grade debt securities (“high-yield bonds” or “junk bonds”); iii) Derivatives; iv) Foreign/International Markets; and v) Emerging market risk.
Risks Associated with Infrastructure
Infrastructure Funds invest exclusively or almost exclusively in equity or debt, or equity or debt related instruments, linked to infrastructure assets. Therefore, the performance of an Infrastructure Fund may be materially and adversely affected by risks associated with the related infrastructure assets including: construction and operator risks; environmental risks; legal and regulatory risks; political or social instability; governmental and regional political risks; sector specific risks; interest rate changes; currency risks; and other risks and factors which may or will impact infrastructure and as a result may substantially affect aggregate returns. Investments in Infrastructure assets are typically illiquid and investors seeking to redeem their holdings in an Infrastructure Fund can experience significant delays and fluctuations in value.
Risk Associated with Hedge Funds
An investment in a hedge fund is speculative and includes a high degree of risk, including the risk of a total loss of capital. A hedge fund is illiquid, subject to significant restrictions on transfer and investors should be aware that they may be required to bear the risks associated with holding such investment for an indefinite period of time. Investors should carefully review the confidential private placement memorandum and other offering documents for the hedge fund strategy prior to making an investment decision. Any investment decision with respect to a hedge fund should be made solely on the definitive and final version of the private placement memorandum, the governing agreements, subscription agreements and other ancillary documents.
Risks Associated with Real Estate
Funds that invest in real estate or property invest exclusively or almost exclusively in equity or debt, or equity or debt related instruments. Therefore, in addition to risks associated with investment in such equity or debt instrument, the performance of the real estate fund may be material and adversely affected by risks associated with the related real estate assets. Past performance of funds investing in real estate are not indicative of the performance of the real estate market as a whole and the value of real property will generally be a matter of a valuer’s opinion rather than fact. The value of any real estate investment may be significantly diminished in the event of a downturn in the real estate market. Real estate investments are subject to many factors including adverse changes in economic conditions, adverse local market conditions and risks associated with the acquisition, financing, ownership, operation, and disposal of real estate.
The information contained in this presentation is proprietary and confidential and may contain commercial or financial information, trade secrets and/or intellectual property of BlackRock. If this information is provided to an entity or agency that has, or is subject to, open records, open meetings, “freedom of information”, “sunshine” laws, rules, regulations or policies or similar or related laws, rules, regulations or policies that require, do or may permit disclosure of any portion of this information to any other person or entity to which it was provided by BlackRock (collectively, “Disclosure Laws”), BlackRock hereby asserts any and all available exemption, exception, procedures, rights to prior consultation or other protection from disclosure which may be available to it under applicable Disclosure Laws.
In Canada, this material is intended for institutional investors, is for educational purposes only, does not constitute investment advice and should not be construed as a solicitation or offering of units of any fund or other security in any jurisdiction.
© 2024 BlackRock, Inc. or its affiliates. All Rights Reserved. BLACKROCK and ALADDIN are trademarks of BlackRock, Inc. or its affiliates. All other trademarks are those of their respective owners.
AIBH0324U/M-3359863
