To Hedge Or Not to Hedge?

INVESTMENT PERSPECTIVES LDI in 2020: To hedge or not to hedge?

Executive summary

We continue to recognize and extol the virtues of pension plans maintaining a high level of liability risk hedging through extended-duration liability-driven investment (LDI) portfolios in the current environment. This applies to both the Treasury duration element Andy Hunt, FIA, CFA and the credit spread duration element, but for different reasons. Senior Investment Strategist, Head of Fixed Income Solutions, Strategic view Tactical view Multi-Asset Solutions, WFAM Underweight modestly Treasury hedge Near 100% hedge (to 80%) Hedge increases to 100% as Overweight (to the extent Credit spread hedge funded ratio increases that capital is available) Introduction

Nearly all corporate defined benefit pension plans in the U.S. have only employed a partial interest rate hedge of their plan liabilities for many decades. This has proved to be a costly strategic position during a long period of secular decline in interest rates. Yet yields today are lower than they have ever been and, at least nominally, are approaching zero. Investors are now asking, “are we finally at the point where liability duration hedging is not a good idea going forward?” Our answer is no … and yes.

We say “no” because fully hedging an unwanted risk remains a good baseline strategic position that we have always advocated. We say “yes,” on the other hand, because we believe there are some reasons why—on a tactical basis—a full hedge might be less justified in current market conditions. Chief among these is a view that future changes to long yields might have become asymmetric and have a bias to rise. Overall, however, despite our preference for a modest tactical underweight, it remains the case that we advocate that most pension plans actually increase their hedge ratio as they are generally starting from a position that is a long way from our strategic norm.

So, what factors into the decision to hedge or not to hedge? Below, we outline the most important considerations in today’s market environment. We conclude with our view on how these factors might inform the hedging policy over a range of plan and sponsor circumstances.

FOR INVESTMENT PROFESSIONAL USE ONLY – NOT FOR USE WITH THE RETAIL PUBLIC October 2020 Motivation to hedge

WFAM assessment of Consideration current conditions Hedgeable uncertainties are often hedged. In order to increase predictability, CFOs Normal routinely hedge a variety of operational risks that are unpredictable, volatile, and Strategic hedging logic is not really correlated with bad scenarios or adverse outcomes. Liability duration risk can affect sensitive to current market conditions. balance sheet and other financial metrics in a similar manner. Why not hedge this as well?

Yield curve forecasting is notoriously difficult. Treasury yield forecasting is a difficult Normal and often fruitless task. Most professional investment managers choose to spend The expected accuracy of Treasury little of their risk budget on raw duration even when permitted to do so. Why, then, yield forecasting is insensitive to should pension plans spend such a large portion—in many cases half—of their risk current conditions. budget on this bet?1

Dollar durations are high. With discount rates low, durations have risen, causing dollar Elevated durations of liabilities to rise faster than those of asset portfolios. Hence, even small The value of unhedged liabilities today is changes in rates have an outsize impact on funded status. At the very least, it can high due to the low current levels of yields. make sense to add to the liability hedge in order to reset back to the dollar duration shortfall that a plan might have had six months or a year ago.

Convexity is never good to be short. Liabilities have a lot of convexity (the second Normal order price impact of changes in yields) due to their very long-dated nature. Asset Convexity is a consistent driver and portfolios, which focus almost exclusively on bonds with less than 30 years to does not change significantly with maturity, have less convexity. Underfunding amplifies this short convexity position. yield changes. Because convexity only ever acts to increase the value of a bond, it is not a good characteristic to be short of.

Don’t want to be short a risk premia. Yield curves are presently upward-sloping Reduced for both Treasury yields and credit spreads. There is a positive expected return The yield curve is currently fairly flat, to extending duration exposure and hedging more liability risk. Indeed, running depressing the value of the term risk a net short position to bond yields due to unhedged liabilities is accepting a yield premium. headwind.

Valuably counter cyclical. Treasury yields tend to fall when the economic outlook is Reduced bleak—therefore, so, too, is the plan sponsor’s business outlook. This coincidence of Our research indicates that the magnitude risk occurs when it matters most: 1. equities down, 2. Treasury yields down (liabilities of any yield decrease would be muted by up), and 3. plan sponsor business down. It’s not that easy to break, but an extensive low starting levels. Treasury hedge is one of the few ways to do it.

If yields are going to rise. If a plan sponsor holds the view that yields are due to rise in Reduced the coming months/years by more than predicted in the forward curve, then it can We have sympathy with the view that be logical to hold a net short position in bond yields. It should be noted, however, yield curve changes are somewhat that any such position should be scaled by the strength of opinion that the decision- asymmetric and biased modestly to maker has and set alongside all other positions in a diversified manner.2 the upside.

When capital is scarce (i.e., it’s needed elsewhere in the portfolio). To the extent that the Normal pension plan assets need to perform two tasks—hedge risks and generate return— This is largely situationally dependent, they need to deliver two exposures. If there is a limit to the capital efficiency that though most plans can access capital- can be employed to gain those exposures, then there can be a limit in terms of efficient instruments in a judicious achieving both aims and a choice has to be made. manner.

1. A risk decomposition of surplus variance for most U.S. corporate pension plans shows around 50% of the risk is attributable to Treasury yield movements. 2. For instance, the view on rising rates should be set alongside tactical views on equity returns, FX returns, etc.; scaled by the risk or uncertainty of each view; and made to fit into the verallo size of the risk budget that the decision-maker is willing to take. 2 Our view

Based upon our research,3 we still believe in the risk reduction characteristics of hedging the Treasury bond exposure in liabilities on a go-forward basis. The potential yield response to equity market drawdowns might be diminished compared with the “golden age of diversification” era from the 1980s through the global financial crisis, but the expected response to economic and equity market stress is still a flight to perceived safety and hence lower Treasury yields. Indeed, this very behavior is being cultivated by the actions and words of central banks across the globe that have strong motivation to keep rates low. Market participants expect this to happen, which generally reinforces the likelihood that it will. So, to the extent that a pension plan—via its liabilities—is ‘short’ Treasury duration, a fulsome hedge is still very much warranted in our opinion.

Our general view is that a near 100% Treasury hedge makes sense for many, if not most, pension plans. This is especially true for mature pension plans, those that are large in relation to their plan sponsor, and those where the plan sponsor’s business is more economically sensitive. Time and time again we all witness unpredictable events and market shocks. At such times, the benefits of improved hedging and the risk mitigation it provides has been manifest. No one can say what the future holds, so risk management discipline seems worthwhile to us. Hedging makes sense.

In terms of tactical positioning, in today’s environment we might be tempted to advocate for an 80% Treasury hedge—i.e., -20% from strategy. This number will vary by the circumstances and views of the pension plan. For example, a very mature plan with a near 100% funded ratio might stick with a 100% hedge as there is little upside to seek to do anything other than hedge. But an open and immature plan with a strong plan sponsor and a particular view might seek to reduce their Treasury hedge to say 60%.

We think the most widely held reason not to hedge stems from a tactical view that yields are going to rise. Ultimately this is a personal decision—it is neither right nor wrong to hold it. Over time, however, we argue that this view should not always be in one direction—that is, it should ebb and flow and therefore any duration stance should be tactical and transitory. In other words, a full or near full duration hedge would still make sense as a strategy and should be reverted to as and when the tactical view has subsided.

Capital efficiency and reluctance to use leverage is something we feel can be engineered around in most if not all cases. Capital-efficient means of accessing many of the important exposures that are required readily exist (e.g., STRIPS, futures, and swaps), meaning effective exposures can be achieved with the available capital. There are limits to this, such as a desire to invest in asset classes that require full funding (e.g., many active mandates) and, for some plans, there might be a self-imposed policy restricting the use of leverage.4 Nevertheless, in our experience, most pension plans have sufficient tools available to them to gain desired exposures.

While all of the above pertains to the Treasury hedge, we think a quick word on credit spread hedging is in order. We have written elsewhere on this issue, acknowledging that the list of considerations is different. Namely, credit spread hedging is a far less meaningful mitigant against adverse market environments. Indeed, in times of economic turmoil, credit spreads tend to widen, suggesting a short position is defensive. But, in the long run, credit spreads are a rewarded risk premium to take advantage of, increasing the yield carry earned by the pension plan and thus enabling the assets to keep pace with the liability discount rate. Furthermore, due to the ongoing COVID-19 uncertainty and changing economic landscape, credit spreads are currently fairly wide by historical standards (and alpha opportunities are high) and, as such, offer long-term LDI investors a good opportunity. So while we are tactically light compared with strategy in Treasury hedging, we are the opposite in terms of credit spreads, favoring more credit spread hedging in the current environment.

3. The Role of Sovereign Bonds, WFAM, 2020 4. For some pension plans, their policy constraint on leverage can be an obstacle. We note that asset leverage for the purpose of hedging needs to be considered differently. As noted, this is being done to reduce a risk that is already present, not to take on a new or different speculative risk. 3 We want to help clients build for successful outcomes, defend portfolios against uncertainty, and create long-term financial well-being. To learn more, investment professionals can contact us:

l To reach our U.S.-based investment professionals, contact your existing client relations director, or contact us at [email protected].

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l To reach our U.S.-based retirement professionals, contact Nathaniel Miles, head of Retirement at Wells Fargo Asset Management, at [email protected].

l To discuss sustainable investing solutions, contact Hannah Skeates or Christopher McKnett, co-heads of Sustainable Investing at Wells Fargo Asset Management, at [email protected] or [email protected].

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute. The views expressed and any forward-looking statements are as of September 25, 2020, and are those of Andy Hunt, FIA, CFA, senior investment strategist, Head of Fixed Income Solutions, Multi-Asset Solutions and/or Wells Fargo Asset Management. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. Discussions of individual securities, or the markets generally are not intended as individual recommendations. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. Wells Fargo Asset Management disclaims any obligation to publicly update or revise any views expressed or forward-looking statements. All investing involves risks, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics. Wells Fargo Asset Management (WFAM) is the trade name for certain investment advisory/management firms owned by Wells Fargo & Company. These firms include but are not limited to Wells Capital Management Incorporated and Wells Fargo Funds Management, LLC. Certain products managed by WFAM entities are distributed by Wells Fargo Funds Distributor, LLC (a broker-dealer and Member FINRA).

FOR INVESTMENT PROFESSIONAL USE ONLY – NOT FOR USE WITH THE RETAIL PUBLIC