It’s not easy being a corporate pension plan sponsor, which is something Gary Veerman, Head of LDI Solutions, Capital Group, fully realizes. Veerman has been thinking about and executing liability driven investment (LDI) strategies for a significant part of his career, and as such he has a terrific knack for helping plan sponsors envision solutions to their challenges in a nuanced and holistic way. Veerman recently spoke with II for what turned out to be a conversation packed with insights, including the customization of benchmarks to more fully exploit existing opportunities in the credit market. 

What’s driving demand for LDI right now? 

Funded status is still the primary driver. For context, we’ve seen one of the longest equity bull markets in history, and plan sponsors have been compensated for the risk they’ve taken in equities. But largely because of seemingly ever-lower rates, alongside some other factors, many plans are still sort of where they were 10 years ago. Recently, we’ve also seen some large companies take advantage of low-interest debt financing and truing up some of their unfunded deficit. 

Except now we’re at or near the end of a cycle instead of the beginning of one – and the road ahead is widely expected to have more frequent volatility spikes. 

That’s the dilemma plan sponsors face – and one very rational solution is to simply move up in the capital structure as an investor. Selling equities and buying credit – in many cases of the same issuing companies – seems a prudent risk management move regardless of the market environment, but particularly so after 10+ years of soaring equity prices. Plus, it feels pretty good to get the de-risking benefits relative to liabilities. 

Where are we in the evolution of LDI? Is there a state-of-the-art strategy? 

If there were a silver bullet, the funded-status challenge would already be solved. But as an organization, we believe it comes down to the blocking and tackling. From an asset allocation standpoint, that can mean focusing on your risk budget and balancing more of that risk toward equities than interest rates – with equity risk being compensated and interest rate risk arguably being non-compensated. From a fixed income implementation standpoint, it involves hiring proven active managers that demonstrated good downside protection in periods of market stress. 

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It sounds as if a key might be for plan sponsors to diversify their credit portfolios. 

Of late I’ve been talking to plan sponsors about private credit, securitized credit, other multi-sector type solutions. It’s smart for plan sponsors to consider all of them, but you also must take a step back and consider the risk and reward tradeoff on an incremental basis relative to a more vanilla approach. 

Here’s an example of what I mean: Private credit may get you, let’s say, 30 to 50 basis points above public market credit, before considering any added risk. If you’re going to allocate 5% of your portfolio to something that potentially gets you 50 basis points, you have to go through all the steps of adding an asset class like private credit to gain two and a half basis points of expected rate of return increase. And we know that things like private credit have liquidity constraints and other factors that will make them track the liabilities less accurately. In short, there are pros and cons to everything. If you’re not very confident that the pros significantly outweigh the cons, stick to the blocking and tackling.

Where are the opportunities for LDI strategies in investment-grade credit at the moment? 

Our belief is that the entire investment-grade long credit universe should generally be the starting point, including BBBs. Sponsors often go up in credit quality or minimize BBB exposure because they’re trying to fine tune relative to a AA-rated discount curve. We understand that, and we do manage such higher quality portfolios. But realistically, that can drive unintended negative consequences for clients. For instance, it can create significant challenges for managers, such as suboptimal liquidity, concentration risk and limited degrees of freedom to generate excess return. We would need to achieve an excess return target just to try to mitigate the liability-relative headwind associated with bond downgrades. Instead of restricting BBBs, sponsors can consider blending full investment-grade long credit with Treasuries or STRIPS to achieve a desired overall quality, while maintaining the integrity of outcomes with the broad investment-grade universe of bonds. 

When a plan sponsor is thinking about that broader credit universe, is the risk of a step down in quality something that should be on their mind? 

That is something we all talk about with plan sponsors. BBBs make up more than half of the Bloomberg Barclays U.S. Long Corporate Index today. Our view is that quite a few of those names moving to BBB in the past few years have been a product of merger and acquisition activity, which has been fueled by the historically low interest rate environment. We believe many of these firms have attainable plans to de-lever and could potentially move up a notch or more on the credit quality spectrum. 

That said, active management is crucial because migration risk certainly exists within the BBB space, particularly in an idiosyncratic way for firms that don’t execute effectively on those de-leveraging strategies. That’s why we’re so keen on fundamental analysis and striving not to put those bonds in our client portfolios and subjecting them to that downgrade risk. 

You seem passionate about the alignment of LDI strategy goals between plan sponsors and managers, including customization of benchmarks. How does that work to an investor’s advantage? 

Fixed income indices sometimes work in strange ways. If you invest per an index, then as issuers take on more debt, you’re buying more of their bonds because they just borrowed more money – that’s very counterintuitive. Whether that’s the government or corporations, that’s a foundational flaw of blindly using that index as a hedging tool. This has important implications for both benchmark customization and portfolio implementation via active management. 

Also, importantly, corporate bonds and equities emanate from the same companies – just different parts of the capital structure. So, when there’s a period of stress and equities take a big fall, those corporate bonds are not likely to perform well. That’s why it’s important to think holistically. Even if you’re giving up a little bit of yield because you’re partially allocating to Treasuries or STRIPS instead of fully to credit, you’re significantly helping yourself from a risk management perspective. 

Do your conversations with plans differ depending on whether they are considering pension risk transfer? 

Yes, but it depends very much on both the anticipated size and the intended timeframe for the pension risk transfer activity. Whether or not in-kind asset transfers to an insurer are feasible depends largely on transaction size, and preparation for such activity can certainly influence investment strategy leading up to the deal. But, again, the expected timeline is also important, and for sponsors without a definitive timeframe, it’s worth considering whether you really want to potentially compromise on-balance-sheet outcomes by trying to fine tune a credit portfolio for an uncertain future transaction. It may be more suitable to structure your on-balance-sheet LDI portfolio for the best outcomes, without losing sight that there could ultimately be transaction cost savings for large plans that hold high quality long corporate bonds and then transfer them to an insurer. 

Is there enough capacity in the marketplace for everyone to execute the strategy they want? 

There’s been a lot of talk around the availability of high quality corporate bonds in the marketplace; that is, if everyone buys long bonds, the math just doesn’t work. What we’ve experienced with significant de-risking is that there’s generally been no problem sourcing those bonds. Foundationally, supply and demand are something to keep an eye on, but ultimately with demand from plan sponsors, companies will come to the table with that supply. So, at the industry level, capacity constraints are probably a little bit overblown, and we don’t see it as a significant headwind anytime in the short to intermediate term. 

On the manager capacity side, you have to wonder: at what point does a $30 billion or $40 billion long credit manager lose their ability to add value? For example, we believe security selection is the most idiosyncratic risk pension plans can add to their LDI program. If you’re a $40 billion book of business and there’s an attractive new issue that comes to market, the impact that has in your portfolio is very likely less than it would be if someone has a $5 billion book of business. The bigger the manager, the more expectations of outcomes should be re-evaluated. Often their tracking error tends to get a lot lower and they don’t have the ability to take the type of risk they want to take, or the sponsor is expecting. One plan sponsor I spoke to called it “closet indexing.” 

Regarding that security selection process, is the research behind it foundational to your LDI strategies? 

It is at the heart of our value proposition; particularly given that we are among the largest active equity managers. Our equity analysts have very different conversations with senior management at companies compared to debt analysts, unsurprisingly, since, for example, certain potential corporate actions may be good for one type of investor but bad for another.  Our equity analysts share those insights with our fixed income analysts in the spirit of partnership and collaboration, and often our debt analysts go to meetings with the equity analysts or just hop on the phone and get those insights directly from the C-level executives in those honest conversations. That’s a huge differentiator. There are other firms that do equities and fixed income, but I challenge you to find one that has a culture of partnership like this one. 

We’ve talked a lot about plan sponsors and the industry. In the context of what you think plan sponsors need, what sets you and your team at Capital Group apart? 

The biggest thing is that we’re privately owned, so we can allocate the resources we need to pursue our investment goals and appropriately resource LDI solutions. We are active managers. We do not have any passive strategies. We will not implement strategies where we do not believe we can add value. Active management is not a philosophy for us, it’s a culture, and that’s vastly different from trying to be all things to all people. As I mentioned earlier, equity markets can be highly correlated with credit markets. When equities are down, there’s a higher probability of widening spreads and credit downgrades creating additional headwind. The last thing you want is your active manager to be down as well. That asymmetry of downside risk management is what LDI is about – and it’s what we aim to provide.