Long Credit in Liability Driven
Investments
A Tragedy of the Commons?
May 2013
port Document Title
Hewitt EnnisKnupp, An Aon Company
Sub-Title
© 2013 Aon plcof Report Document
Date
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Key Points

As corporate pension plans increasingly embrace dynamic Liability Driven Investment (LDI) strategies
to de-risk, we believe demand for long duration credit will increase to unprecedented levels.

Our analysis shows that the current U.S. Long Credit market would need to grow enormously—four to
seven times the typical annual issuance—to meet the additional demand.

We believe that over the long-term, markets will adapt to this increase in demand for Long Credit, but
there may be dislocations in both pricing and liquidity over short- and medium-term horizons.

Credit spreads of these bonds would likely narrow in the event of such a demand/supply squeeze,
making hedging strategies more expensive.

There are several implications to consider:
–
First, corporate plans on de-risking glide paths should have investment strategies and
governance processes that are adaptable to changing market conditions. Such strategies may
include the use of a hedge path (a more well-defined interest rate risk budget) and the ability to
separate hedging decisions for credit spreads and interest rates.
–
Second, by moving into Long Credit, corporate pension plans likely will be exposed to lowerquality credit issues than the liability discount rate. This may suggest the use of more government
bonds as plan sponsors de-risk.
–
And finally, annuitizing pensions could become expensive and place additional demands on Long
Credit from the insurance sector.
Tragedy of the Commons
Ecologist Garrett Hardin coined the term “Tragedy of the Commons” in a 1968 paper in the journal
Science1. It refers to the overuse of a shared resource by individuals, depleting the resource to the point
of hurting the entire group. One example Hardin’s paper describes is that of overgrazing community farm
land. Each farmer gets individual benefits from letting his herd graze on the land, but the damage from
overgrazing is borne by the group. While each farmer has incentive to put larger herds on the land than is
preferable, the entire group suffers. This is the consequence of an imbalance between individual and
collective interests.
1
Hardin, Garrett. “The Tragedy of the Commons.” Science 13 December 1968: Vol. 162 no. 3859 pp. 1243-1248.
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In finance, we see the potential for a real-world imbalance. There are a tremendous number of corporate
pension plan sponsors2 developing strategies to de-risk as funded status increases and/or interest rates
rise. These de-risking strategies almost always include plans to significantly increase allocations to Long
Credit. Hewitt EnnisKnupp continues to recommend these types of investment strategies to many of our
clients. With so many plan sponsors planning to buy the same type of asset, will there be an imbalance
between supply and demand? Will this create a tragedy of the commons, in which plans sponsors acting
rationally in their best interest collectively cause a shortage that could negatively impact all who do not act
quickly enough?
This paper analyzes the supply and demand of U.S. Long Credit in detail. While we believe markets are
adaptable to changes in supply and demand, a sufficiently large change in the dynamics of supply and
demand can create a bumpy ride along the path to a new equilibrium. Our analysis indicates a high
likelihood of a substantial imbalance between supply and demand under a wide range of scenarios. We
consider what this means for investors trying to be the “smart money” in a complex market environment.
In Hardin’s example of a “Tragedy of the Commons”, the herders doing the best are those who anticipate
the problem in advance and make contingency plans for where their livestock will graze when the land is
depleted. Similarly, investors will be well-served by anticipating a potential imbalance between the supply
and demand for Long Credit and planning their investment strategies accordingly.
2
This paper refers to “corporate pension plans,” but also includes other types of plan sponsors subject to the Pension Protection
Act, such as many types of non-profits. These plan sponsors are subject to a regulatory environment that increases demand for
Long Credit.
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Embracing Dynamic Liability Driven Investments (Dynamic LDI)
with Long Credit
A combination of changes in pension funding and accounting rules and volatility in capital markets has
driven many corporate pension plan sponsors to begin adopting LDI strategies. Pension plan sponsors
employing an LDI strategy develop their asset allocation with liabilities as the focal point. Dynamic LDI
strategies, also known as de-risking glide paths, increase a plan’s allocation to long duration fixed income
assets as the plan’s funded ratio improves. This method for de-risking has gained broad acceptance
among plan sponsors. About two-thirds of plan sponsors anticipate changing asset allocation based on
funded status3 and in conversing with plan sponsors, we believe the number will increase over the next
several years.
Illustrative De-risking Glide Path
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
90%
30%
70%
75%
80%
85%
90%
95%
100%
Funded Ratio
Long Duration Fixed Income
Equity
The de-risking of private pension plans will likely generate tremendous demand for long duration fixed
income assets. In recent years, investors have tended to favor Long Credit over Long Government,
because of low Treasury yields and higher-than-typical credit spreads. In addition, the Long Credit index
tracks corporate pension plan discount rates better than the Long Government, leading many plan
sponsors to benchmark their liability-hedging assets to Long Credit.
3
Pension & Investments survey of private defined benefit sponsors in 2012, as cited in the article “2 of 3 Pension Plans Use LDI,
With More Coming” at www.pionline.com on 04/16/2012.
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Imbalance of Supply/Demand Expected in U.S. Long Credit
Market
The Long Credit market makes up only a fraction of the U.S. credit market.
U.S. Credit
U.S. Long Credit
Total Market Value (2012)
$4,576 BB
$1,304 BB
Total Outstanding Par Value (2012)
$ 3,981 BB
$ 1,039 BB
Average Annual Issuance (2010-2012)
$ 403 BB
$ 157 BB
Rolling 12-Month Average Daily Trading Volume
(12/31/2012)
$ 8.3 BB
$ 1.7 BB
Individual Issuers (12/31/2012)
1,169
659
Historical Average Rolling 12-Month Growth Rate
Based on Outstanding Par Amount (1973-2012)
9.2%
6.2%
Source: Securities Industry and Financial Market Association (SIFMA), Barclays Live & J.P. Morgan
Traditional institutional investors in Long Credit include insurance companies and investors with Barclays
Aggregate bond mandates (which include a sliver of long duration bonds). Currently, the allocation to
4
Long Credit by corporate DB plans only accounts for approximately $126 billion , about 10% of the total
U.S. Long Credit market. We expect a dramatic increase in demand as many plans anticipate buying
more Long Credit when their funded status increases and/or interest rates rise. We estimate the future
aggregate demand for Long Credit by corporate DB plans will be $1.25 trillion in our baseline case, while
more conservative assumptions suggest an increase over $700 billion. At four to seven times the average
annual issuance over 2010-2012, the incremental demand will require the U.S. Long Credit market to
expand substantially, nearly doubling the current size.
Both our baseline and conservative sets of assumptions suggest dramatic increases in the demand for
Long Credit. This increase is primarily driven by frozen (i.e., no future benefit accruals) and closed (i.e.,
future hires are excluded) plans which will have very high allocations to liability-matching Long Credit
when they are close to 100% funded; which will be caused by regulatory funding requirements.
Of course, this increased demand will likely materialize over an extended period of time. We think that
seven years is a reasonable baseline estimate, as it aligns with the Pension Protection Act’s (“PPA”) rules
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for amortizing unfunded liabilities . The issue will be even more dramatic because the increased demand
will not be steady; it will occur sporadically, as funded statuses increase and interest rates rise. We
believe this will cause temporal price dislocations, which plan sponsors may capitalize upon with wellarticulated risk budgets, governance structures and flexible investment options.
4
5
6
Estimated based on Greenwich survey on DB plans’ asset allocation and DB plans’ asset performance.
Detailed calculation in Appendix 1.
MAP-21 funding relief legislation passed in 2012 may extend this time frame by 2-3 years.
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The Long Credit market has experienced rolling 12-month growth rates in the range of -2.1% to 24.6%.
Assuming the U.S. Long Credit market expands at the median historical growth rate of 5.6% continuously
for seven years, corporate DB plans would need to consume an amount in the range of 48% to 79% of
entire supply of the Long Credit market over that time period. Additionally, we have no reason to expect
significant decreases in demand from other traditional buyers of Long Credit. The demand by corporate
DB plans could cause a supply and demand squeeze even in a dynamic market.
Corporate DB Plans Estimated Consumption of U.S. Long Credit
Market Capacity in 7 years
Share of U.S. Long Credit
Market Capacity
160%
140%
120%
100%
79%
80%
48%
60%
40%
20%
0%
10th
20th
30th
40th
50th
60th
70th
80th
90th
99th
Scenarios of Long Credit Market Growth in Percentiles
Current Share of Long Credit Market Capacity
Percentile
10th
20th
30th
40th
50th
60th
70th
80th
90th
99th
Conservative Estimate
Baseline Estimate
Rolling 12-month Growth Rate
1973-2012
-2.1%
0.7%
2.8%
3.9%
5.6%
7.3%
9.3%
12.6%
16.9%
24.6%
Source: Barclays Live
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Impact on U.S. Long Credit Market and Beyond
It’s true that markets are adaptive to changes in supply and demand, but how can we predict market
behavior and cost? To understand the various ways markets might adapt, we considered how factors
such as, increasing debt issuance, use of derivatives, lump sum settlements and regulatory changes,
might change the supply and demand squeeze described above.
Though the strong demand for Long Credit could induce issuers to assume more long duration debt, the
market may be challenged to solve the imbalance through new issuance alone. The financial, industrial
and consumer services sectors are traditionally major issuers of Long Credit, but these sectors have
significantly deleveraged since 2008. Due to the Dodd-Frank and Basel III overhaul of the regulation of
the financial industry and the subsequent credit rating downgrades on many international banks in 2012,
it’s unlikely that financial institutions will re-leverage quickly to the peak level seen prior to the financial
crisis. The consumer services and energy sectors have maintained consistent leverage ratios over the
past seven years. Even if the industrial sector increases debt ratios back to the prior peak level, the
additional issuance would probably not be enough to meet the pressing demand from pension plans. Low
interest rates and narrow credit spreads may encourage more debt issuance and restructuring of existing
debt to longer maturities. If demand drives interest rates and credit spreads to meaningfully lower levels,
it would substantially alter Long Credit supply.
Using Long Government bonds in combination with credit default swaps is, theoretically, a way to expand
the supply of Long Credit by creating it synthetically. Similarly, investors could also create Long Credit
synthetically with interest rate swaps and credit default swaps, possibly used in combination with
intermediate duration bonds. The interest rates used would be based on government or swap yields, and
the credit spreads would typically be based on a CDX basket of credits. As both of these have significant
basis risk relative to the interest rates and credit spreads in physical long bonds and the liability discount
rate, we remain skeptical of the practical merits of this strategy. Further, with the additional complexities
of investing in the derivative markets, we do not believe the strategy will be a mainstream solution in the
U.S., unless physical Long Credit bonds become less desirable than they are today.
Lump sum settlements could naturally reduce demand in each relevant asset class, including Long
Credit, and our estimate incorporates an assumption that 30% of plan liabilities are settled with lump
sums. This represents most of the terminated vested participants and some actives. While a significantly
greater proportion of lump sums is theoretically possible, it is not our baseline view, as it would require
major increases in lump sums to actives or retirees. Mass lump sums for actives are only possible upon
plan termination, which is unlikely to happen until more plans become well-funded (i.e., >90%). Lump
sums for retirees were not thought to be allowed until the recent transactions by Ford and GM, which
required private letter rulings from the IRS. If the trend escalates over the next several years, lump sums
could substantially reduce the additional demand for Long Credit, though we have not yet seen evidence
to warrant an adjustment to our view of the demand for Long Credit. (Annuity settlement, in contrast to
lump sums, only transfers the demand for long duration bonds from plan sponsors to insurance
companies.)
Governed by PPA laws, corporate plans will have limited room to adapt their demand for Long Credit to
the stressed market. If there were an imbalance in supply and demand, relief might come from the
regulatory front. Any future change of PPA laws pertaining to funding needs or liability discount rates can
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change the demand for Long Credit. However, without any evidence that such a change is forthcoming,
such a factor is speculative.
Without far-reaching changes, the current U.S. Long Credit market may soon face challenges in meeting
the potential demand from corporate DB plans. The unprecedented imbalance of supply and demand is
likely to stress the market. Markets tend to find suppliers of assets in strong demand, but at a price. This
suggests a narrowing of credit spreads at the long end of the yield curve, a scenario that has not yet
occurred. In fact, the opposite is happening in the current market: the gap between credit spreads at long
and intermediate durations is at historically wide levels.
Relative Option Adjusted Spread
Long Credit vs Intermediate Credit
1.0%
0.8%
0.6%
0.4%
0.2%
0.0%
-0.2%
-0.4%
-0.6%
-0.8%
-1.0%
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Source: Barclays Live
This implies that the demand for Long Credit is not outpacing the supply, so the mass movement into
Long Credit has not yet hit a tipping point. We believe this is the quiet before the storm. Entering the
market now might provide a first-mover advantage and allow for purchasing Long Credit while spreads
are still favorable. As other market participants flood into Long Credit in the years to come, those who
purchase it now will benefit from narrowing spreads.
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Impact on Plan Assets / Liabilities and Beyond
Depending on the price at which Long Credit purchases are made, pension plans could either benefit
from or become a victim of massive inflows. Corporate pension plans risk turning their future common
thirst for Long Credit into a “Tragedy of the Commons.” While the capital market scenario described
above would greatly benefit existing holders of Long Credit, it would also make it extremely unattractive
for corporate DB plan sponsors to continue buying into the asset class. Tighter credit spreads, as well as
higher transaction costs from poor liquidity, may ultimately make Long Credit a very expensive hedging
choice for plans late to the de-risking process. Before following “the herd” into an overgrazed Long Credit
market, corporate pension plans should gauge whether they still have the first movers’ advantage to
capture.
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Investors also need to be aware of the shift of credit quality composition of the U.S. Long Credit market .
Over the past decade, Baa-rated issuers have contributed the highest growth among the four credit
ratings in Long Credit. Lower-credit quality is one of the risks defined benefit plans could unintentionally
take on. At crisis moments, lower-rated holdings could potentially increase the downside risk of a plan’s
funded ratio. From February 1999 to June 2012, in 47 out of 67 months in which the S&P 500 monthly
return was negative, the credit spread of Barclays Long Credit Index widened. One strategy to mitigate
this risk is to invest in a combination of Long Credit and Long Government bonds, which can provide an
average credit quality at the desired level.
Be a Dynamic De-Risker
We continue to believe that LDI implemented with a dynamic investment policy can be an effective derisking solution for corporate defined benefit plans; however, plan sponsors need to be aware of changing
market conditions as they move forward. Realizing it is difficult to project how soon the demand factors
will start materializing, we recommend that plan sponsors consider contingent strategies for implementing
a glide path.
Current Fed policy has provided clear guidance that it is committed to keeping interest rates low through
the middle of 2015. At the time this article is being written (April 2013), Hewitt EnnisKnupp believes that
the yield curve beyond 2015 is more likely to steepen, as the Fed’s impact on long end yield starts to
fade. We recommend considering the following two-step strategies for de-risking glide paths. The first
step relates to current positioning and the second to future positioning.
7
See detailed Long Credit quality evolution over the past two decades in Appendix 2
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Step 1: Reposition Current Portfolio
Plan sponsors that do not believe long-term interest rates will rise in the medium-term (or believe they will
rise, but do not want to manage their portfolios based on that view) would be less concerned about the
duration risk caused by potentially rising interest rates. We recommend that these plan sponsors move
early, transitioning part or all of the Long Government holdings to Long Credit. Plan sponsors can
then gain the first mover’s advantage from expected narrower credit spreads while keeping their asset
duration intact. These plan sponsors can also achieve better hedging, as Long Credit tracks the discount
rate better than Long Government.
Plan sponsors that believe long-term interest rates will rise (as Hewitt EnnisKnupp does), and are willing
to position their portfolios based upon that view, will want their fixed income portfolios to include some
intermediate duration. We recommend these plan sponsors buy Long Credit physical bonds to the
extent their glide path allows and shorten duration with derivatives (i.e., a “Futures and Physicals”
approach); this takes advantage of the term structure of credit spreads and a potential future
narrowing of credit spreads at the long end of the curve. A hedge path is an effective governance
tool for managing the interest rate hedge ratio and separating the interest rate and credit spread
hedging decisions.
Step 2: Plan for Future Strategy
As funded ratios improve, plan sponsors will need to evaluate whether they are already experiencing an
overgrazed Long Credit market. Plan sponsors may monitor the following indicators in evaluating the
relative attractiveness of Long Credit to assess whether they are already disadvantaged by the market
dynamics:

Broad increases in average funded ratios that cause plans to de-risk

Reduction in credit spreads that cannot be justified by macro-economic conditions

Observation of an inverted or humped credit spread curve
If Long Credit still appears to be attractive, we encourage plans to buy Long Credit as early and
aggressively as their glide paths allow. If Long Credit appears expensive, plans should be open to other
long duration instruments, such as Long Mortgages and Global Long Credit. The choice should be based
on the evaluation of hedging efficiency and attractiveness of returns. Long duration diversifiers can be
added as part of the plans’ active Long Credit managers’ mandates, if they possess the requisite
expertise.
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Summary
For legitimate reasons, the insatiable appetite for Long Credit could lead private pension funds into an
overgrazed Long Credit market. We estimate the incremental demand for Long Credit solely by private
pension funds to be four to seven times the average annual issuance from 2010 to 2012, which could
result in a demand / supply squeeze in the Long Credit market. Markets will adapt over the long-term, but
there could be a bumpy road to a new equilibrium. Factors such as increasing issuance and lump sum
settlements could potentially offset the demand, but we believe they will not solve the market imbalance
over the short term. The market imbalance could narrow credit spreads on the long end and have
unintended consequences for corporate pension plans. We suggest these plans make adjustments to
position their portfolios for a very different market for Long Credit. We encourage corporate pension plans
to be open to other hedging options when the Long Credit market gets overcrowded. To effectively
implement a dynamic investment policy, plan sponsors need to adjust their portfolios dynamically,
considering both the plan’s funded status and market conditions.
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Appendix 1
This appendix documents our methods for estimating the increase in demand for Long Credit. Our
analysis incorporated several major factors driving changes in the demand for Long Credit:

Improvements in funded ratio. The average plan is underfunded, and funding rules will force plan
sponsors to make contributions to close the gap after the net impact of market performance.

Increase in LDI usage. Many corporate plans do not have all of their fixed income in long duration
strategies, because they are concerned about potentially rising interest rates. Eventually most of
these fixed income assets will move to long duration.

Glide path de-risking. Many plans will de-risk when funded ratios increase. Most frozen and closed
plans will be invested predominantly in long duration fixed income when fully funded, and many open
plans will have higher fixed income allocations than currently.

Discount rate increases. These would reduce the liabilities and the total assets needed to be fully
funded, and thus decrease the Long Credit needed when fully funded.

Over-weight credit. Though the Barclays Long Government/Credit Index remains the most common
benchmark for plan sponsors, we expect a trend toward over-weighting credit as allocations to fixed
income rise. This increases the hedging efficacy, as liability discount rates are based on corporate
bond yields.

Lump sums. Many plan sponsors will offer lump sums to active employees and/or terminated vested
participants. This allows them to reduce the plan liabilities, and thus the assets needed.
Our estimation process began by assessing the size of the private defined benefit plan market. Total
assets of private defined benefit plans were valued at $2.2 trillion at the end of 2009, based on the data of
U.S. Department of Labor. Hewitt EnnisKnupp’s pension survey on companies in the S&P 500 indicated
total assets of private defined benefit plans grew 12% in 2010, 3% in 2011 and 12.6% in 2012 (data from
Investment Metrics) respectively. We estimated the total assets of private defined benefit plans to be
$2.86 trillion at the end of 2012.
The same survey confirmed:

The average funded ratio of corporate DB plans was 80% at the end of 2011

Average asset allocation: Equity 48%, Fixed Income 41%, and Alternatives 11%
Corporate DB plans’ current allocation to Long Credit is estimated to be $126 billion using assumptions in
the shaded area of the table on the following page.
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To estimate the incremental fixed income asset demand, we used the following assumptions:
Base Case
Assumptions
2,858
80%
3,573
Conservative
Case
Assumptions
$2,858
80%
$3,573
Fixed Income Allocation
Allocation to Long Bonds (% of FI)
Allocation to Long Credit (% of Long Bonds)
40%
22%
50%
40%
22%
50%
Percentage of plans that are frozen
Percentage of plans that are closed
Percentage of plans that are open
40%
25%
35%
40%
25%
35%
Percent of end-state FI in long duration – frozen
Percent of end-state FI in long duration – closed
Percent of end-state FI in long duration – open
100%
100%
75%
100%
100%
75%
End state FI for frozen plans
End state FI for closed plans
End state FI for open plans
Percentage of open plans on glide paths
Average FI for all plans at 100% funded
90%
90%
60%
50%
76%
80%
75%
40%
50%
65%
Percentage that will get lumped out once fully funded
End percentage of long bonds in Long Credit
30%
75%
30%
60%
Discount rate increase
Liability Duration
Liability Accrual
Aggregated Demand for Long Credit ($bb)
1.00%
12.00
None
$1,199
2.00%
12.00
None
$733
Incremental Demand for Long Credit ($bb) from the
base in 2012
$1,073
$607
Estimate Inputs
Private Pension Plan Assets ($bb) at The End of 2012
Average Funded Ratio
Private Pension Plan Liabilities ($bb) at The End of 2012
Based on these assumptions, our baseline estimate is that the total demand for Long Credit among
corporate DB plans sponsors will increase from $126 billion to $1,199 billion, and our conservative
estimate is that it will increase to $733 billion. Other assumptions could support a different range, but we
believe any reasonable set of assumptions will produce massive inflows into Long Credit and do not
materially alter the overall thesis of this paper.
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Appendix 2
Over the past two decades, the U.S. Long Credit market has seen a decline in average credit quality.
Data on the Barclays Long Credit index shows that issues were mostly concentrated in AA and A in the
early 1990s, as compared to a greater concentration in A and Baa today.
Long Credit Credit Quality Evolution
50%
45%
45%
40%
40%
34%
35%
30%
30%
23%
25%
20%
15%
13%
12%
10%
3%
5%
0%
Aaa
Aa
12/31/1990
A
12/31/2000
Baa
12/31/2012
Source: Barclays Live
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Contact Information
Fei Amy Shang, CFA
Consultant
Investment Solutions
Hewitt EnnisKnupp
+1.312.715.3311
[email protected]
Eric Friedman, FSA, EA, CFA
Associate Partner
Hewitt EnnisKnupp
+1.312.715.2973
[email protected]
Russ Ivinjack
Senior Partner
Hewitt EnnisKnupp
+1.312.715.3330
[email protected]
Phil Kivarkis, FSA, EA, CFA
Partner
Hewitt EnnisKnupp
+1.847.442.3825
[email protected]
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About Hewitt EnnisKnupp
Hewitt EnnisKnupp, Inc., an Aon plc company (NYSE: AON), provides investment consulting services to
over 450 clients in North America with total client assets of approximately $2 trillion. More than 240
investment consulting professionals in the U.S. advise institutional investors such as corporations, public
organizations, union associations, health systems, endowments and foundations with investments
ranging from $3 million to $700 billion. For more information, please visit www.hewittennisknupp.com.
About Aon Hewitt
Aon Hewitt empowers organizations and individuals to secure a better future through innovative talent,
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clients to cultivate talent to drive organizational and personal performance and growth, navigate
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on Aon Hewitt, please visit www.aonhewitt.com.
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