Taking Credit in the Long Run
IN PRINT ARCHIVE CIR Fall 2009
Taking Credit in the Long Run
By Paul Purcell, senior director, institutional client relationships and Aubrey Basdeo, head of Canadian fixed income, Barclays Global Investors.
With 20/20 hindsight, we can say that January 2009 was the right time to invest in credit. But is it still the right time? With credit spreads now substantially lower than the beginning of the year, it’s fair to say that the easy money has been made already. So much for the tactical—how about the strategic? For corporate plan sponsors, a strategic case for credit from an asset-liability framework can be argued.
That their pension plans have a big mismatch between the interest rate exposure of their assets and liabilities is well known. Less appreciated is that they have an even bigger mismatch between the credit spread exposure of their assets and liabilities. When determining the position of a pension plan for financial statement purposes, the accounting standards for both Canadian and U.S. GAAP dictate that pension liabilities be determined with a discount rate referenced to high-quality corporate bonds. This is generally interpreted to be AA quality and means that billions of dollars of pension liabilities in Canada are appraised based on the very thin market for long-term AA bonds. How thin is thin? In Canada, as at May 31, 2009, there were eight AA corporate bonds that extend beyond 10 years, with a total market value of $2.5 billion.
Wide credit spreads provided substantial relief to companies reporting their pension plan position in 2008 year-end financial statements, as plan liabilities declined on the blowout in spreads on corporate debt. But the relief is limited and likely to be temporary. First, the accounting liabilities have no influence on cash funding requirements, which use Government of Canada bond yields as the reference point for solvency liabilities. Second, with credit spreads pulling in, 2009 year-end accounting liabilities are going to be much higher.
However, there is a fly in the ointment of this hedging argument. Pension plan asset allocation is a fiduciary function. It is questionable whether financial statement reporting should be a fiduciary consideration. The strategic arguments for credit, as for any investment, revolve around expected risks, returns and portfolio diversification.
Investing in credit has provided a risk-adjusted return premium over government bonds in recent periods. The DEX Universe can be subdivided into two components: the DEX Corporate Bond Index and the DEX Government Bond Index. When measured over the period from January 1, 1980 to May 31, 2009, and for rolling 10-year periods within that timeframe, the DEX Corporate Bond Index has produced a modestly higher return-to-risk ratio than the DEX Government Bond Index.
The diversification benefit of adding credit exposure to a portfolio needs to look beyond superficial asset class labels to the underlying systematic risk premia. Risk premia are to asset classes as atoms are to the molecule. Credit gives exposure to various risk premia: economic uncertainty, inflation and interest rates, and illiquidity. These are obviously not unique to credit. However, most pension funds are far from diversified across risk premia, and an allocation to credit is typically helpful. Extreme risk aversion and lack of investor demand has given way to risk seeking and a shortage of credit supply. “Is now the time to invest in credit?” may be a simple question, but it demands a very thoughtful answer.