Credits: an affordable solution to matching problems
Recent market volatility has shown that market developments can wipe out pension fund reserves rather quickly. This has forced plan sponsors to increase pension fund contributions sharply. However, volatility in these contributions is considered undesirable as it has a direct impact on plan sponsors’ results. In addition, new regulation will require pension funds to value liabilities on a mark-to-market basis. Future pension fund reserves will depend not only on the development of the assets’ value, but also on the change in value of liabilities. A matching approach can protect pension fund reserves against movements in financial markets. If government bonds are used to achieve this, matching can be a very costly solution. However, research shows that credits are highly suitable for matching portfolios. Using credits, Robeco now offers pension funds an affordable solution to match assets and liabilities.
Robeco has developed a solution for the problems pension funds have in matching their liabilities. The following subjects will be discussed in the remainder of this article:
q How to reduce a pension fund’s risks by immunising interest-rate risk
q What is the added value of credits in a matching portfolio
q How to hedge real liabilities in a pension fund
q What capabilities are needed to manage a matching portfolio.
The article ends with a summary of the features of the matching product that Robeco offers to pension funds.
How to avoid interest-rate risk?
Both assets and liabilities can be seen as future cash flows. The present value of future cash flows is dependent on interest rates. If interest rates change, the present value will change. The sensitivity of the value of the future cash flows to interest-rate movement is measured with delta. Delta can be calculated for all maturities on the yield curve. This makes it possible to measure the sensitivity to all possible movements in the yield curve.
Delta can be calculated for both assets and liabilities. If the total delta of assets and liabilities is equal, than the pension fund is protected against parallel movements in the yield curve. To ensure that the pension fund is protected against non-parallel movements in the yield curve, deltas have to be equalised for all maturities on the yield curve.
Robeco uses its proprietary RoVar system to calculate deltas for both assets and liabilities. The matching of an account can be assessed based on the RoVar output. Potential mismatches can be corrected using the RoVar output to ensure that assets and liabilities are perfectly matched.
What is the added value of credits?
If the matching strategy is implemented using government bonds, the assets and liabilities can be matched. The disadvantage of using only government bonds is the limited yield that they offer. This will increase the total cost of funding for the pension plan. Investing in credits is an alternative that could be considered.
The upside of credits is the higher yield offered compared to government bonds. Default risk is the most important risk long-term investors in credits bear. Credits are an attractive long-term investment as long as the higher yield they generate compensates for the cost of defaults. The uncertainty of potential future defaults implies a risk for a matching portfolio. If the number of defaults in the portfolio is higher than estimated, the realised return on assets may be lower than expected.
To get a better understanding of the potential of investing in credits the historical spread of credits versus governments is calculated. The euro credit market has a short history, so data for the US credit market are used. The numbers in figure 1 illustrate that credits generate a substantial spread over government bonds. Especially lower-rated credits like BBB and BB bonds offer an attractive spread over government bonds. Based on quantitative research we have estimated the possibilities to fund the liabilities on a spread of 75 basis points over governments.
Investment decisions should always be made in a risk and return framework. Most investors are used to the Markowitz framework, where risk is measured as the standard deviation of the returns. However for a pension fund the probability of being underfunded is a more relevant risk measure. A pension fund is underfunded if the asset returns are insufficient to pay its liabilities.
For long-term investors the greatest risk of investing in credits is default risk. A high number of defaults could lead to the pension fund being underfunded. To estimate the cost of default, historical default matrices can be used. Default probabilities differ over time. To take this uncertainty into account, we use simulation methods to construct a large number of potential default scenarios.
In the research project, we calculated the probability of underfunding if the liabilities are funded with governments plus 75 basis points. The probability of underfunding was calculated for several types of investment portfolios. These investment portfolios are displayed in table 2. The investment portfolios have different allocations over the investment categories. One investment portfolio has a small allocation in equities. The leveraged portfolio uses credit default swaps to create a leveraged position in credits.
For each of the investment portfolios we calculated the probability that the investments will generate a return less than 75 basis points over governments. This is defined as the probability of underfunding. The return of the investment portfolios is compared to the level of 75 basis points over governments. The difference is defined as the excess return of the investment portfolio. For an investment portfolio the probability of underfunding is compared to the excess return. The results are displayed in figure 2.
The first conclusion from the figure is that an allocation towards lower-rated credits reduces the shortfall probability, while at the same time the expected excess return increases. This illustrates the added value of credits in a matching portfolio. Leveraged credit shows particularly strong results in the matching context. The portfolio with an allocation to equity has a high return, but the shortfall probability is also high. The reason for this high probability is that maturity matching of liabilities is not possible with equity. This example illustrates the amount of risk reduction that can be achieved by using matching techniques.
Based on the results of its quantitative research Robeco recommends that pension funds should use credits to match their long-term liabilities. Spreads on credits offer more than sufficient compensation for their actual default risk. The high spread on credits is also a compensation for liquidity and short-term price risk, which are less relevant for long-term investors. Investing in credits can reduce the cost of the pension plan, while at the same time the probability of underfunding is limited.
Example: reducing pension-fund costs
Consider a pension fund which has to pay out e1m a year for the next 30 years. If the plan sponsor wants to hedge its liabilities at this moment, then its choice of investment mix has a big impact on the costs of the pension plan.
If yields on government bonds are 4% for all maturities, then the total cost of the funding ise17.3m. Investing in credits can reduce these costs. We use historical spreads for the different investment mixes, after correction for expected default costs (table 3).
Using credits reduces the cost of funding between 10% and 13%, depending on the chosen investment mix. The results will depend on actual credit spreads and the maturity profile of the liabilities.
Nominal versus real liabilities
Most pension funds want to offer inflation indexation to their participants. If a pension fund only invests in bonds with nominal coupons, it is not possible to guarantee inflation indexation. Pension funds could consider investing in inflation-linked bonds to hedge their inflation guarantee. The drawback of this asset class is the limited number of available bonds in the euro universe at the moment. Currently only higher-rated debtors issue inflation-linked bonds, which limits the real yields offered.
An alternative to hedge inflation is the use of inflation swaps. In an inflation swap pension funds can receive the actual realized inflation over a specific time period. Pension funds have to pay the inflation level that is priced in at the moment, which is known as break-even inflation. An inflation swap offers the opportunity to transfer nominal cash flows into real cash flows.
Example: inflation swap
For a 10-year maturity, the current break-even inflation level is 2% annually. In an inflation swap the pension fund can receive the actual inflation over the 10-year period and has to pay the 2% break-even inflation. The difference in value is exchanged at maturity. The nominal value of the swap is 100. If the actual realised inflation is 3%, then the pension fund will receive 12.5 at maturity.
An alternative investment strategy is to invest in a portfolio of credits combined with an inflation swap which hedges the inflation guarantee. This solution combines the best of both worlds as it offers both higher yields and protection against inflation.
What capabilities are needed to manage the portfolio?
To manage a matching portfolio successfully an investment manager needs specific investment capabilities. First they have to make risk calculations to assess the matching of a portfolio. Robeco has developed its proprietary RoVar system to make matching calculations. RoVar is able to deal with all kind of investment instruments, including derivatives, and currently is used for the management of e4bn in matching portfolios.
Credit-selection capabilities are a second requirement. Selection of credits is based on historical default probabilities. If the pension fund manages to avoid defaults, the total cost of the pension plan can be reduced. To avoid defaults, investors must carry out in-depth credit analysis of potential issuers. Robeco is one of Europe’s most sophisticated credit houses, and has extensive experience in analysing credits and managing credit portfolios.
Derivatives like interest-rate swaps, cross-currency swaps and asset swaps play an important role in the management of matching portfolios. Experience in using these instruments is a key capability. Risk management of derivatives needs to have a key role in the investment process. Robeco has an independent Risk Management Department which reports directly to its Executive Board, and its systems are able to handle all sorts of derivatives.
Leveraged credit investments are attractive for long-term investors like pension funds. The most straightforward way to create leveraged credit portfolios is to use credit default swaps. Leveraged credit is one of Robeco’s spearheads, and its credit team manages e6.5bn exposure in credit default swaps.
Robeco’s matching product
Robeco offers pension funds a matching product with the following characteristics:
q A strong emphasis on the matching of assets and liabilities, which reduces a pension fund’s risk. Robeco uses its proprietary RoVar system for matching calculations.
q Matching solutions depend heavily on the liabilities which have to be matched. Robeco can offer tailor-made solutions for clients.
q Investment in credits to reduce a pension plan’s costs. Research illustrates the added value of credits for matching portfolios.
q Within the product, either nominal or real returns can be generated.
q The portfolios are managed by Robeco’s credit team, which has extensive experience in managing credit portfolios. Robeco is considered to be one of Europe’s most sophisticated credit investors.
The combination of the above characteristics makes the Robeco matching product a very compelling solution for pension funds.