A roadmap to designing a corporate bond strategy

Spread capturers seek to lock in a yield by investing in long-dated, cash flow-matching credit, focusing on issuers with higher credit ratings. Sharpe maximisers, by contrast, focus on generating the best risk-adjusted returns and invest in shorter maturity credit, with additional spread gathered by investing in lower-rated issues.

The implications for income generation and buyout price-matching should also be considered when designing a corporate bond strategy.

If the aim is to match buyout prices, holding some credit is likely to make sense; however, a high allocation to long-duration credit will lead to higher asset volatility, which may not be reflected in buyout prices

Spread capturers

Spread capturers are focused on securing their long-term funding outcome by, as far as possible, locking in a yield until their pension scheme’s benefit payments are due. They are more likely to be able to look beyond short-term funding level volatility. This is the approach most often associated with traditional cash flow-driven investing, or approaches that seek to invest like an insurer.

This involves investing in credit that matches the cash flow profile of the liabilities as far as possible with a low default risk, thereby minimising reinvestment risk. Ultimately, this should maximise the certainty of achieving the pension scheme’s long-term funding objectives.

However, as a pension scheme’s liabilities have a long duration – typically around 20 years – this also implies investing in credit with a long duration. Long-duration credit has a high sensitivity to changes in credit spreads. Therefore, spread capturers should either have a high tolerance of short-to-medium-term funding level volatility, or a mechanism to match their liability discount rate to the credit spreads of the assets they are holding.

The latter approach comes with a health warning. First, discount rate-matching is not straightforward in practice, as the liability cash flows are likely to be more granular and longer-duration than the credit portfolio. Second, it may be possible to match the technical provisions, but this approach will not match the discount rate used to value the Pension Protection Fund liabilities or, in likelihood, the cost of buyout.

For these reasons, spread capturers should carefully consider the strength of their sponsor covenant.

Sharpe maximisers

Sharpe maximisers are more concerned about short-to-medium-term funding level outcomes. They are focused on generating the best risk-adjusted returns and therefore the emphasis will be on investing in corporate bonds that are likely to deliver the best risk-adjusted returns over the same time period.

This often means investing in shorter maturity credit, with additional spread gathered by investing in lower-rated issues.

Investing in shorter-dated bonds frees up risk budget to invest in corporate bonds issued by lower-rated companies, such as those in the space where investment grade meets high yield (BBB and BB rated), to generate extra spread.

These cross-over stocks can benefit from market anomalies, which a benchmark-unconstrained bond manager can exploit to earn more attractive risk-adjusted returns than if investing in the highest rated bonds only. 

There tends to be greater sector and name concentration at longer maturities. 

Additional considerations

In theory, if a pension scheme invests in similar gilts or swaps to insurers and the right credit instruments, it should be able to hedge the investment component of buyout pricing reasonably accurately.

However, buyout pricing is more likely to reflect the investment strategy backing the insurance company’s new business, rather than covering the insurer’s whole book.

Increasingly, insurers are casting their net wider in the search for higher yield and tilting to non-traditional asset classes such as equity release mortgages and infrastructure debts.

The investment strategy, and therefore impact on pricing, will be idiosyncratic from provider to provider and will vary over time.

If the aim is to match buyout prices, holding some credit is likely to make sense; however, a high allocation to long-duration credit will lead to higher asset volatility, which may not be reflected in buyout prices.

Cash flow generation

If a pension scheme is seeking cash flow to pay pensions, it should be able to achieve this with either type of credit portfolio.

Cash flow is a natural consequence of a spread capturer portfolio, while a Sharpe maximising scheme can generate cash flow using a combination of the income from the corporate bonds and the liquid assets that are used to back the liability-driven investment.

In this case, a suitable liquidity management process is required to ensure that pension cash flows can be met while also maintaining sufficient, but not excessive, cash to support the margining/collateral requirements of the LDI positions. The process can be also be designed to minimise the risk of being a forced seller of the credit.

Finally, valuation and spreads are also a consideration. All else being equal, a spread capturer approach will be more attractive when spreads are higher, assuming of course that this more than compensates for any additional credit risk – something that clearly needs careful consideration given current market uncertainty.

Jonathan Smith is client portfolio manager at BMO Global Asset Management