Liability-driven investing in a low-yield environment

Put simply, LDI is the realisation that the returns on plan assets should match or exceed returns on plan liabilities. Currently, yields are low; and this implies low returns on fixed income scheme assets. However, it also implies low returns on plan liabilities.

Therefore, the primary questions a defined benefit scheme sponsor needs to address are: can stocks and other return-seeking assets also be expected to achieve lower returns in this environment than previously? Similarly, what are the prospective returns for risk assets versus hedge assets versus liabilities?

Current yields argue more for long governments than long credit

While long AA spreads have declined recently, the spread premium for long credit over DB liabilities has not declined. This indicates that long credit and long government credit portfolios are just as attractive as hedges of liabilities today as they were when yield levels were more elevated

Over the past few years, lower yields have been accompanied by lower credit spreads.

Since DB liabilities are evaluated for accounting purposes via AA yields, AA spreads measure the yield “deficit” suffered by US Treasuries relative to DB liabilities.

Long AA spreads have moved lower in recent years, while the premia of long credit and long government credit spreads over long AA spreads have held steady or even increased a bit on net, especially so for long government credit.

The lower AA spreads mean that despite the lower yields, US Treasuries are actually a more effective hedge of liabilities now than they were five to 10 years ago.

Meanwhile, the relatively elevated levels of long credit spreads over long AA spreads indicate that long credit is just as attractive a hedge of DB liabilities as it has been through most historical experience. Long government credit currently offers a more attractive hedge of liabilities than it did through most of the past 30 years.

For liability-hedging purposes, both long government credit and long credit allocations are more attractive than was the case when AA yields were higher.

Prospective equity returns have declined just as much

Of course, for LDI purposes, it is all relative. Fixed income might appear more attractive as a hedge of liabilities now than it did previously, but for determining whether and how much to hedge, the relevant question is how long government credit and long credit look relative to return-seeking assets.

To address this question, we must analyse how prospective returns on equities and other risk assets have changed as yields have declined. 

While equities generally still offer a prospective return premium over corporate bonds and US Treasuries, this premium has declined substantially over the past year.

As of year-end 2020, it stood at levels as low as any point in US post-war history with the exemptions of: 1987, the eve of the Black Monday stock market crash; 1999, the peak of the dotcom bubble; or 2010, the eve of the 2010-11 stock sell-off.

This, however, does not imply that the stock market is overvalued or that DB plans should get out of stocks. Rather, the point is that the low levels of yields everyone bemoans are accompanied by similarly low prospective returns on equities.

The message of LDI amid low yields

For a DB plan, which has a well-defined liability target for its asset allocation to meet or exceed the level of yields per se does not matter.

What matters are the yields available on its assets relative to those on its liabilities and the prospective returns on return-seeking assets relative to those on hedge assets.

While fixed income yields have declined across the board in recent years, prospective returns on equities appear to have declined in tandem, and just as much.

And while long AA spreads have declined recently, the spread premium for long credit over DB liabilities has not declined. This indicates that long credit and long government credit portfolios are just as attractive as hedges of liabilities today as they were when yield levels were more elevated.

Meanwhile, our best estimates are that the relative return premiums for equities over bonds is relatively, low as of this writing, suggesting that in our view this is not an encouraging time for DB plans to be moving into equities. This is the simple message of LDI.

Michael Bazdarich is product specialist and economist at Western Asset