Fixed Income

Liability driven investing: alpha matters more than you think

12/09/2015

For a hedging allocation, many believe that the main goal should be minimizing tracking error to a suitable benchmark, not seeking benchmark out-performance. We would challenge this view.

Executive summary

  • The Schroders Fixed Income team examines the phenomenon of the ‘downgrade effect’ by constructing their own LDI models in order to analyze the potential impact security downgrades would have on a hypothetical plan with index matching liabilities.
  • While most LDI investors are aware of a “downgrade effect”, many may be surprised at its magnitude and persistence. A large part of this phenomenon can be attributed to the fact that liability valuation discount rates “have no memory” of bonds that are downgraded out of the ratings universe, while their impact remains with corresponding assets.
  • A similar effect is evident in the realized excess returns of credit indices. These fail to achieve the yield spreads at purchase as “forced sales” of downgraded bonds essentially lock in downgraded prices.
  • Earned excess return has been highly dependent on spreads at purchase.
  • The team then goes on to examine how comparing manager performance versus an asset benchmark can provide a misleading view of “risk” for a corporate pension plan.
  • Relying solely on a low index tracking error/passive corporate bond strategy will almost certainly “lock in” persistent underperformance and meaningful tracking error vs. liabilities. Therefore, investors should consider the merits of active management in LDI, which offers the potential to buy and sell the ‘right’ bonds at the ‘right’ time in order to improve liability returns.

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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.