By: Yoshie Phillips, CFA, Senior Research Analyst OCTOBER 2011 Long duration bond benchmarks for corporate pension plans Issue: With the growth of liability-driven investing (LDI), many corporate pension plans are adopting long-duration indexes for the benchmarking of their fixed income portfolios, in place of traditional broad-market indexes, such as the Barclays Capital U.S. Aggregate Bond Index. The three most common long-duration indexes are the Barclays Capital Long Government/ ( G/C ) Index, the Barclays Capital Long Index and the Barclays Capital Long Index. What are the differences between these indexes? Response: Any of these three long-duration indexes acts as a starting point for reducing the duration mismatch between a pension plan s liabilities and its assets. However, each has certain limitations. Of the three, the Long G/C Index offers the best liquidity and diversification. However, it has a large allocation to Treasuries that are not exposed to corporate spread volatility. The Long Index presents a close proxy to a pension plan s liabilities in terms of its pure corporate allocation. However, it has a narrower universe than the Long G/C and Long indexes, and concentration in specific names becomes an issue. The Long Index is broader than the Long Index, because it includes non-corporate credits such as taxable municipal bonds and bonds from sovereign, supranational, foreign agency and foreign local government issuers. This index offers better diversification than the Long Index, but moves further away from the definition of liabilities as defined by the Pension Protection Act of 2006 (PPA) discount curve. Russell Investments // Long duration bond benchmarks for corporate pension plans
In order to balance these considerations and help minimize tracking error relative to liabilities, plan sponsors sometimes prefer a blended benchmark (e.g., 50% Long G/C, 50% Long ). As allocations to LDI portfolios increase in the future, greater customization of benchmarks to specific liability cash flows will likely become necessary (see, for example, Jaugietis et al 2011). Background When corporate DB plans first extend duration of their fixed income portfolios in a liability-driven investing (LDI) framework, they most often do so by using one of three Barclays Capital indexes Long Government/ (G/C), Long or Long. Each of these indexes is a reasonable first step, because: 1. It closes a plan s short-duration position versus its liabilities, and 2. It better matches the credit quality of that plan s discount rate. However, given that the Pension Protection Act of 2006 (PPA) dictates the use of a corporate bond universe of A to AAA rated credit quality to construct a plan s liability discount curve, none of these is a perfect solution. Understanding the characteristics of those major long-duration indexes is an important step in constructing a benchmark. This paper highlights the differences in these indexes and the trade-offs if one were to use a single cash bond index as a starting point. Major characteristic comparison The major characteristics of the long-duration indexes relative to the Barclays Capital U.S. Aggregate Bond Index are listed in Exhibit 1. Given that a plan s liability discount curve utilizes A to AAA rated credit quality, the Long A to AAA universe is also included in this comparison chart. Durations for the long-duration indexes are over 12 years, much closer to a typical duration of DB pension liability than the duration of the U.S. Aggregate index. Among the four long-duration indexes, the Long G/C and the Long A to AAA indexes marginally have the longest average duration. However, the Long G/C has 40% of its weight in U.S. Treasuries, which provides better liquidity and diversification but reduces exposure to corporate spread volatility. The Long A to AAA offers the best match in terms of credit quality as it is applied as a proxy for the liability discount rate used in the pension plan calculation. At the same time, the investable universe becomes much more constrained for the Long A to AAA index compared to other long-duration indexes, as indicated in Exhibit 1 by number of issues and market value. Exhibit 1: Major characteristic comparison (as of 06/30/2011) Government / Barclays U.S. Characteristics Aggregate Duration (years) 5.19 13.22 12.47 12.64 13.02 Average credit quality AA1/AA2 AA3/A1 A2/A3 A2/A3 A1/A2 Market value ($MM) 15,217 1,726 971 759 435 Yield (%) 2.83 5.05 5.76 5.82 5.62 Option-adjusted spread (OAS) (bps) 54 96 168 172 149 Number of issues 7,979 1,487 1,378 1,076 571 (A AAA) Russell Investments // Long duration bond benchmarks for corporate pension plans / p 2
Sector allocation comparison Compositions vary among the long-duration indexes, as illustrated in Exhibit 2. For instance, while the major characteristics of the Long and Long indexes are similar, there are some differences between the two. The biggest difference is that Long is a pure play on corporate bonds, while Long includes taxable municipal bonds and bonds from non-corporate sectors such as sovereign or supranational, foreign agency and foreign local government issuers. Basically, the Long Index consists of the Long Index and the non-corporate sectors. The financial sector represents almost 30% of the Long A to AAA index, as financial companies issue tremendous amounts of debt, including longer-maturity paper. Exhibit 2: Sector allocation comparison (as of 06/30/2011) Government / (A AAA) Barclays U.S. Sector allocation (%) Aggregate 19.80 43.96 78.16 100.00 100.00 Financials 7.15 9.50 16.90 21.62 28.38 Utilities 2.18 7.23 12.86 16.46 15.48 Industrials 10.48 27.22 48.40 61.92 56.13 Sovereign/Supernational 2.54 4.33 7.70 - - Agency/Local authority 8.94 11.70 14.14 - - Treasury 32.89 40.01 - - - Securitized 35.83 - - - - TOTAL 100.00 100.00 100.00 100.00 100.00 The non-corporate sector accounts for approximately 20% of the Long Index, in an increase over the last several years; it accounted for roughly 12% of the index 10 years ago (see Exhibit 3). For the non-corporate sector in the Long Index, Build America Bonds (BABs), which are taxable municipal bonds, currently make up approximately 8% of the Long Index. However, the BABs presence will likely decline over time, as the BABs program was not extended. Countries like Brazil and Mexico have increased their sourcing of capital through the U.S. bond market; their presence has grown over the last 10 years to put them within the top 10 issuers for the Long Index. These two countries sovereign debt represents roughly 3% and 2%, respectively, of the Long Index as of 2010 year-end. DB plan sponsors who are interested in tracking the overall U.S. corporate market should be aware of the noncorporate aspects of the Long Index if considering its use as a benchmark. Exhibit 3: Historical change of Long Index Composition (as of 06/30/2011) December 2000 (%) December 2005 (%) June 2011 (%) By quality Aaa 4.80 5.70 3.06 Aa 17.00 13.00 16.72 A 44.80 39.50 39.59 Baa 33.40 41.80 40.63 By sector Non-corporate 12.00 15.00 21.60 88.00 85.00 78.40 Russell Investments // Long duration bond benchmarks for corporate pension plans / p 3
quality breakdown Given that the BBB-rated category makes up 42% of the Long Index, some plan sponsors might view the Long Index as having too much credit-spread risk relative to plan liabilities, as liabilities are often discounted using the corporate bond universe of issuers rated A or better. However, in practice, restricting choices to investable corporate bonds rated A or better will considerably limit the opportunity set. There are only 533 issues rated A or better in the Long Index (see Exhibit 4), making up approximately $440 billion in market value. On the market value basis: the size of the Long A to AAA universe makes up less than half of the market value of the Long Index. Exhibit 4: Long Index Constituents (as of 06/30/2011) Aaa, 1.38% (16 issues) Aa, 11.87% (81 issues) Baa, 42.63% (499 issues) A, 44.12% (474 issues) The segment of the A to AAA rated corporate bond market is overly concentrated in a limited number of issuers. To further comment on the concentration risk: if BBB-rated corporate bonds are excluded from the investment universe, the largest two current issuers alone AT & T and General Electric would make up more than 10% of the A- rated and better-rated corporate universe. This is not a practical solution for plan sponsors, as it introduces significant concentration risk as well as potential deterioration in funding status should those concentrated positions be downgraded to below A-rated. While including BBB-rated corporate bonds might introduce unwelcome price volatility to the overall portfolio, it certainly offers a diversification benefit derived from expanding the investable universe. Liability cash flows vs. index cash flows The key rate duration for any public long-duration indexes is noticeably different from the key rate duration exposure of typical pension liabilities. To demonstrate the point, Exhibit 5 illustrates the cash flows of the Long Index (which are very similar to those of the Long Index) as compared to the cash flows of the PPA bond universe. The significant gap in the key rate duration exposure of these long-duration indexes versus pension liabilities calls for additional thought as to how best to address it. Russell Investments // Long duration bond benchmarks for corporate pension plans / p 4
Exhibit 5: Cash Flow Comparison PPA Bond Universe and Long Index (as of 12/31/2010) 300 250 200 Millions ($) 150 100 50-2010 2015 2020 2025 2030 2035 2040 2045 2050 Long CFs PPA Universe CFs Source: Barclays Capital; PPA Bond Universe (U.S., A-rated or better, maturities <=30 years as defined by IRS) Cash flows: Barclays Live Historical data is not indicative of future results. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. RELATED READING Jaugietis, M., Thomas, M., and Gannon, J. (2011). LDI benchmarking: When does the basis risk of an LDI hedge begin to matter? Russell Research Russell Investments // Long duration bond benchmarks for corporate pension plans / p 5
For more information: Call Russell at 800-426-8506 or visit www.russell.com/institutional Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of the document. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Diversification does not assure a profit and does not protect against loss in declining markets. Liability Driven Investment (LDI) strategies contain certain risks that prospective investors should evaluate and understand prior to making a decision to invest. These risks may include, but are not limited to; interest rate risk, counter party risk, liquidity risk and leverage risk. Interest rate risk is the possibility of a reduction in the value of a security, especially a bond or swap, resulting from a rise in interest rates. Counter party risk is the risk that either the principal or an unrecognized gain is not paid by the counter party of a security or swap. Liquidity risk is the risk that a security or swap cannot be purchased or sold at the time and amount desired. Leverage is deliberately used by the fund to create a highly interest rate sensitive portfolio. Leverage risk means that the portfolio will lose more in the event of rising interest rates than it would otherwise with a portfolio of physical bonds with similar characteristics. Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield ("junk") bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages. Russell Investment Group, a Washington USA corporation, operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. The Russell logo is a trademark and service mark of Russell Investments. Copyright Russell Investments 2011. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. First used: October 2011 USI-10977-10-13 Russell Investments // Long duration bond benchmarks for corporate pension plans / p 6