A Shorter Long Credit

Steve Mullin , Steven Lucey , Emma Maley

JUN 14, 2024

On a recent trip through the southeast meeting with clients, plan sponsors and consultants, the team found itself in a familiar post-COVID setting (coffee shop) having a far reaching LDI conversation with a field consultant. As the discussion meandered through a variety of topics from Pension Risk Transfer to asset allocation, we ended up on the topic of liability hedging portfolios and the evolution of that portfolio for a closed and frozen plan with a duration that continues to shorten. The consultant made a very simple observation that intrigued us. He said, “The Long Credit Index is just too long for some of my clients.”

While this is certainly not a new concept, we were curious if the current array of solutions properly addresses this problem or if there might be a better alternative.

For the most part, issues of duration and curve exposure can be addressed via overlay management or custom blended benchmarks. These are very familiar and common approaches to meet the interest rate and spread duration needs of the liability hedging portfolio. Market benchmarks offer ample liquidity, and their standard adoption allows for better comparison of a manager’s relative performance. A drawback to the standard blending approach that is not often discussed is the mismatch in credit key rate exposure. Blending long and intermediate benchmarks allows a plan to match the average spread duration of its liabilities but uses key rates across the curve from as short as 1-year out to as long as 40+ years. This ultimately exposes closed and frozen plans to points on the curve longer than their liabilities.

We decided to explore the concept of a “shorter” Long Credit using maximum maturity constrained benchmarks to see how it may solve for the key rate conundrum. We compared two of these Indices with both the Long Credit Index and a sample blend of Intermediate and Long Credit. The tables on the next page show some of our key findings.

Maturity constrained benchmarks can potentially match top level statistics of a shorter liability at the expense of some issuer diversification.

Avoiding key rate exposure to the longest portions of the Long Credit Index can potentially provide a better hedge for closed and frozen plans.

Top-level sector exposures do not materially drift in maturity constrained indices.

The same can be said for credit quality, which is further supported by the lack of variability in the OAS distribution of the respective Index options.

While we don’t anticipate a wholesale shift from traditional market benchmarks or overlay management that are the mainstay of today’s LDI playbook, we do believe it is worth discussing the fallbacks of the path well-trodden. Closed and frozen plans with recently improved funded status likely find themselves considering how to best protect their gains versus the liability. Given the historic flatness of the interest rate and credit curves, many of these plans have unknowingly benefitted from longer key rate exposure and a shorter Long Credit may very well have a role in their hedging solution.

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