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Institutional Investment - October 23, 2013

Analysing and Decomposing the Sources of Added-Value of Corporate Bonds in Institutional Investors' Portfolios

According to international accounting standards SFAS 87.44 and IAS19.78, which recommend that pension obligations be valued on the basis of a discount rate equal to the market yield on AA bonds, the most straightforward way for pension funds to match liability payments is to build a portfolio of long-dated, investment grade corporate bonds. In practice, institutional investors including pension funds, but also insurance companies, sovereign funds, etc., are actually showing an increasing appetite for corporate bonds, not only for their liability hedging benefits, but also for their performance benefits related to the presence of a credit risk premium, which is imperfectly correlated with the equity risk premium. This trend has been accelerated by the recent sovereign bond crisis, which has made high quality corporate bonds an attractive alternative, or a least complement, to Treasury bonds in investors’ portfolios.

The present publication, which is drawn from the Rothschild & Cie research chair at EDHEC-Risk Institute on “The Case for Inflation-Linked Corporate Bonds: Issuers’ and Investors’ Perspectives,” provides a formal analysis of the benefits of corporate bonds in investors’ portfolios, distinguishing between the impact of introducing them in performance-seeking portfolios and the impact of introducing them in liability-hedging portfolios. From a formal standpoint, our analysis is cast within the context of the liability-driven investing (LDI) paradigm, a disciplined investment framework that advocates splitting an investor’s wealth between a dedicated liability-hedging portfolio (LHP) and a common performance-seeking portfolio (PSP), in addition to cash (Martellini (2006), Martellini and Milhau (2012)).

While the LDI paradigm implies that investor welfare should depend on how good each building block is at delivering what it has been designed for (namely risk-adjusted performance benefits for the PSP and hedging benefits for LHP), the intuition suggests that the interaction between performance and hedging motives should also play an important role. We analyse this effect and show that investor welfare can be improved by the design of performance-seeking portfolios with improved liability-hedging properties, or conversely by the design of liability-hedging portfolios with improved performance properties.

To see this, we first introduce a formal decomposition of investor welfare in terms of performance and hedging benefits, and show that a residual term remains, which can be interpreted as a cross-effect emanating from the interaction between performance and hedging motives. This result, which we call the “fund interaction theorem”, is important in that it shows that investor welfare indeed includes contributions from the PSP and the LHP, but also cross-contributions related to the hedging potential of the PSP. When negative, the cross-contribution signals the presence of a conflict between the performance and hedging motives, such as a short (long) position required for performance purposes and a long (short) position required for hedging purposes. This cross-contribution can be substantial for some parameter values, and sometimes equal or superior in magnitude to the performance and hedging contributions. The practical implications of the fund interaction theorem is that investors will in general benefit from improving hedging characteristics of the PSP, unless this improvement is associated with an exceedingly large decrease in Sharpe ratio.

In the end, the net impact will be positive or negative depending on the relative strength of the following two competing effects. On the one hand, the PSP with improved hedging benefits can represent a higher fraction of the investor’s portfolio for a given risk budget; on the other hand, the PSP with improved hedging properties may have a lower performance: hence the trade-off is between an increase in performance due to a higher allocation to risky assets, and a decrease in risk-adjusted performance due to a lower reward for each dollar invested.

In an empirical analysis, we find that corporate bonds are particularly well-suited to improve the PSP/LHP interaction, given that they have a well-controlled interest rate risk exposure while providing an access to an equity-like risk premium. In other words, they have on the one hand attractive interest rate hedging benefits which should help improve the correlation of the PSP with the liabilities compared for instance to an equity investment. On the other hand, they exhibit a higher expected performance compared to sovereign bonds due to the presence of a credit risk premium. These two properties make them natural candidates for inclusion in the performance portfolio, where the primary focus is on achieving a high expected return, and where a high correlation with liabilities helps to align performance and hedging motives, and also in the liability-hedging portfolio, where the primary focus is on interest rate risk hedging, and where the presence of a credit risk premium also contributes to aligning performance and hedging motives more effectively than what is allowed by sovereign bonds. As recalled above, if liabilities are discounted at the risk-free rate plus a spread, corporate bonds may actually hedge liability risk better than sovereign bonds do, precisely because they include a credit spread component that evolves in line with the discount rate on liabilities.

This research was produced as part of the "Case for Inflation-Linked Corporate Bonds: Issuers’ and Investors’ Perspectives" research chair at EDHEC-Risk Institute, in partnership with Rothschild & Cie.