On the go: An illiquidity premium has appeared in long-dated investment-grade bonds, according to consultancy Aon, which has urged clients to take advantage of coronavirus volatility to turbo-charge their matching allocations.
Corporate bond yields in both IG and high-yield markets have leapt to their highest point of the past decade in recent months, as fears of locked-down businesses defaulting and investors rushing to cash sparked a sell-off.
UK and US IG paper fell by 5 and 4 per cent respectively in Q1, with the credit spread on UK IG bonds moving to 2.59 per cent from around 1 per cent at the start of April.
According to Aon, the much larger increaser in the spread of bonds than has been seen in credit default swaps – thought to be a more accurate measure of market default expectations – offered an attractive point of entry for defined benefit schemes.
This excess return was a reward for the illiquidity of holding IG bonds in the current time, the company concluded. By selling gilts used to power the liability-driven investment strategy, but increasing the leverage in this part of the portfolio, schemes could pick up extra return while maintaining the same hedge ratio.
Diversifying-growth assets could also be sold, Aon said, calculating an uptick in scheme returns as a result.
"Notwithstanding the adverse economic impact of Covid-19, Aon believes now is an attractive point to incorporate global investment-grade credit into your liability-driven investment strategy to harvest the elevated illiquidity element available within current credit spreads, particularly in longer-dated credits," the report read. "Perhaps 0.5 per cent p.a. could be added to expected returns, and investment risks like trustees’ cash flow risk and sponsors’ future accounting position volatility, reduced."
The coupons and redemption proceeds of this credit allocation could also be used to match schemes' next 12 years of liability payments, the report stated. Near-term liabilities could be met with short-dated bonds and asset-backed securities, with long-dated bonds weighted toward industrials meeting longer-term payments.
