- Long-dated government bonds have relatively low yields and return prospects. Yet for defined benefit plan sponsors, the attributes these securities offer – including downside risk mitigation, liquidity, and the ability to fine-tune alignment with discount rate credit quality – make them potentially important.
- Fortunately, bundling long-dated government bonds and credit exposures in an actively managed portfolio has the potential to add alpha above what could be achieved in separately allocated strategies managed in a low discretion or passive manner.
- In addition to improved return potential, a bundled approach may yield operational advantages, lower transaction costs and more straightforward rebalancing.
Most liability-driven investing (LDI) portfolios deployed by private defined benefit plan sponsors combine long-dated credit and long government (or Treasury) bonds. The optimal weighting of these components depends on several plan-specific factors, including the nature of the plan’s discount rate methodology, its asset allocation, and the duration and curve exposure of its liabilities. Whatever those weightings may be, the decision to combine credit and government bonds in blended LDI mandates (the bundled approach) or to separate them into sector-specific mandates (the unbundled approach) is among the most consequential decisions plan sponsors have to make.
As we wrote last year in “The Great LDI Paradox: Long Government Bonds and Active Management,” bundled LDI approaches are likely to lead to superior outcomes relative to a collection of disparate unbundled mandates. Today’s interest rate environment, heralded by sub-1% 10-year Treasury yields, only reinforces that case. Indeed, by blending Treasury allocations with credit exposures in an integrated actively managed LDI portfolio, plan sponsors may be able to unlock a substantial amount of alpha potential to supplement relatively low returns expected from Treasury bonds. This, in turn, can help plan sponsors access the benefits generally associated with long-dated Treasury bonds – including downside risk mitigation, liquidity to source benefit payments, and better alignment of LDI credit quality exposure with liability discount rates – while significantly reducing the very high opportunity cost currently associated with owning long Treasury bonds.
Treasury yields are at historically low levels and there is a growing realization that return prospects for those instruments should be meaningfully lower going forward (see Figure 1).
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That said, many corporate defined benefit plans will continue to own long Treasury bonds to address other objectives. These include:
- Providing downside risk mitigation and diversification of return-seeking allocations
- Aligning overall credit risk of the LDI portfolio with that of liability discount curves
- Achieving duration hedge ratio targets
- Supplying liquidity for benefit payments or rebalancing needs, especially during challenging markets