EDHEC-Risk Concept Industry Analysis Featured Analysis Latest EDHEC-Risk Surveys Features Interviews Indexes and Benchmarking FTSE EDHEC-Risk Efficient Index Series FTSE EDHEC-Risk ERAFP SRI Index EDHEC-Risk Alternative Indexes EDHEC IEIF Quarterly Commercial Property Index (France) Hedge Fund Index Research Equity Index Research Amundi "ETF, Indexing and Smart Beta Investment Strategies" Research Chair Rothschild & Cie "Active Allocation to Smart Factor Indices" Research Chair Index Regulation and Transparency ERI Scientific Beta Performance and Risk Reporting Hedge Fund Performance Performance Measurement for Traditional Investment CACEIS "New Frontiers in Risk Assessment and Performance Reporting" Research Chair Asset Allocation and Alternative Diversification Real Assets Meridiam Infrastructure/Campbell Lutyens "Infrastructure Equity Investment Management and Benchmarking" Research Chair Natixis "Investment and Governance Characteristics of Infrastructure Debt Instruments" Research Chair Société Générale Prime Services (Newedge) "Advanced Modelling for Alternative Investments" Research Chair CME Group "Exploring the Commodity Futures Risk Premium: Implications for Asset Allocation and Regulation" Strategic Research Project Asset Allocation and Derivative Instruments Volatility Research Eurex "The Benefits of Volatility Derivatives in Equity Portfolio Management" Strategic Research Project SGCIB "Structured Investment Strategies" Research ALM and Asset Allocation Solutions ALM and Private Wealth Management AXA Investment Managers "Regulation and Institutional Investment" Research Chair BNP Paribas Investment Partners "ALM and Institutional Investment Management" Research Chair Deutsche Bank "Asset-Liability Management Techniques for Sovereign Wealth Fund Management" Research Chair Lyxor "Risk Allocation Solutions" Research Chair Merrill Lynch Wealth Management "Risk Allocation Framework for Goal-Driven Investing Strategies" Research Chair Ontario Teachers' Pension Plan "Advanced Investment Solutions for Liability Hedging for Inflation Risk" Research Chair Non-Financial Risks, Regulation and Innovations Risk and Regulation in the European Fund Management Industry Index Regulation and Transparency Best Execution: MiFID and TCA Mitigating Hedge Funds Operational Risks FBF "Innovations and Regulations in Investment Banking" Research Chair EDHEC-Risk Publications All EDHEC-Risk Publications EDHEC-Risk Position Papers IPE EDHEC-Risk Institute Research Insights AsianInvestor EDHEC-Risk Institute Research Insights P&I EDHEC-Risk Institute Research for Institutional Money Management Books EDHEC-Risk Newsletter Events Events organised by EDHEC-Risk Institute EDHEC-Risk Smart Beta Day Amsterdam 2017, Amsterdam, 21 November, 2017 EDHEC-Risk Smart Beta Day North America 2017, New York, 6 December, 2017 Events involving EDHEC-Risk Institute's participation EDHEC-Risk Institute Presentation Research Programmes Research Chairs and Strategic and Private Research Projects Partnership International Advisory Board Team EDHEC-Risk News EDHEC-Risk Newsletter EDHEC-Risk Press Releases EDHEC-Risk in the Press Careers EDHEC Risk Institute-Asia EDHEC Business School EDHEC-Risk Executive Education EDHEC-Risk Advances in Asset Allocation Blended Learning Programme 2017-2018 Yale School of Management - EDHEC-Risk Institute Certificate in Risk and Investment Management Yale SOM-EDHEC-Risk Harvesting Risk Premia in Alternative Asset Classes and Investment Strategies Seminar, New Haven, 5-7 February, 2018 Investment Management Seminars Contact EDHEC-Risk Executive Education Contact Us ERI Scientific Beta EDHEC PhD in Finance
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.