Real interest rates have increased substantially in recent years, making real yields offered by global inflation-linked bonds, particularly US TIPS, more attractive than they have been in a long time. The Bloomberg US TIPS Index had a real yield of 2.0% as of July 17, which has slightly decreased from its recent peak but is still over 300 basis points above its all-time low set in 2021. This is a substantial move. Consequently, real yields in the United States have approached the 65th percentile of their historical distribution, which ranks best among global peers. Additionally, ten-year real yields in the United States surpass the yield implied by the trend growth rate of the economy (a proxy of their fair value) by nearly 1 standard deviation—another indication that real yields are elevated.

With the rise in real interest rates, investors can once again consider inflation-linked bonds a viable inflation hedge. These bonds pay a real return plus inflation over their life, making them appealing for buy-and-hold investors with significant exposure to real liabilities. Their value diminished when real yields neared zero or turned negative and inflation remained muted, as was the case for much of the previous decade. Today, however, both real yields and inflation have risen, making the math for inflation-linked bond returns more favorable. At a minimum, inflation-linked bonds should return around 2% at maturity, assuming inflation is 0%, but they should return between 4% and 5% if the markets’ expectations about inflation averaging slightly above 2% prove correct, and possibly 5% to 6% if inflation exceeds expectations.

In addition to compensating investors for inflation over time, inflation-linked bonds should perform well in another inflation shock. According to our scenario-based return projections, commodities and inflation-linked bonds are the only two major asset classes we expect to have positive annual real returns in a scenario modeled on an inflationary environment like the 1970s, with 7% average inflation over the next three years. Unlike most other inflation-sensitive assets, inflation-linked bonds typically offer a real yield and lower volatility. They are also resilient in various economic scenarios, including typical deflationary shocks associated with most recessions. Because of these unique characteristics, inflation-linked bonds may provide more broad-based portfolio diversification benefits and superior long-run returns than other inflation-sensitive assets, such as commodities, in both nominal and risk-adjusted terms.

While there is a lot to like about inflation-linked bonds, they do have shortcomings. They tend to underperform other high-quality bonds, such as nominal Treasury bonds, over short periods when inflation falls and over time when realized inflation is below expected inflation. They also exhibit less liquidity and have faced pressure during previous periods of stress, such as in March 2020. Additionally, inflation-linked bonds are sensitive to rising real interest rates, which can partially offset their inflation benefit over short periods. This sensitivity led to their unsatisfying performance during the recent bout of inflation. However, higher starting real yields make this less of a headwind today. Based on our modeling, US TIPS would return 2.6% per annum over the next three years in a stylized scenario based on a repeat of the 2021–23 inflation shock—a marked improvement from the actual -1.3% per annum return they achieved from 2021 to 2023. Performance would be even better if the rise in real yields is less pronounced, given that they are not as depressed as they were previously. We would still expect inflation-linked bonds to underperform other inflation-sensitive assets in this scenario, as they tend to have a lower beta to inflation. Still, even though investors may not get the most bang for their buck in an inflation shock with inflation-linked bonds, they can feel confident that these bonds once again provided a reliable hedge against inflation and have outperformed other inflation-sensitive assets, usually with less volatility, in the long run.

Given their attractive real yields and unique characteristics, investors should consider inflation-linked bonds a valuable component for portfolio diversification in today’s uncertain economic environment. For buy-and-hold investors with significant exposure to real liabilities, these bonds provide a reliable hedge against inflation and have historically outperformed other inflation-sensitive assets with less volatility over the long term. In an era of heightened economic uncertainty, where inflation poses a potential risk, including inflation-linked bonds can enhance portfolio resilience and provide peace of mind.

TJ Scavone, Senior Investment Director, Capital Markets Research

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The reduction in the ECB’s policy rates was well signalled by governing council members and was enabled by a persistent disinflationary environment over the past year. While preliminary inflation data for May came in hotter than anticipated, headline inflation has nonetheless moderated from a peak of 10.6% in 2022, to 2.6%. However, the recent uptick in sequential monthly inflation prints has served to curtail the total quantity of easing expected from the ECB this cycle. At the beginning of the year, approximately eight cuts were expected, with the trough priced in for late 2025. By contrast, between five and six cuts are now cumulatively priced in through the end of 2026.

The Federal Reserve’s peers have typically lagged its moves in monetary policy, particularly in cutting cycles, for fear of material currency depreciation, which could result in imported inflation. That worry is ameliorated for the ECB this time around by a couple of factors. One is that the market has already priced in a certain amount of policy divergence between the United States and Eurozone, thereby mitigating the market impact when this eventuates. The other is that the growth impulse is lower in the Eurozone—the first quarter improvement notwithstanding—and would more clearly benefit from a reduction in interest rates.

While the level of inflation has, until now, hampered the ECB’s ability to cut rates to support economic activity in the bloc, policymarkers’ confidence has grown that inflation will return to their 2% target. Business indicators, such as PMI output prices and the euro area survey of selling price expectations, have been reliable leading indicators of inflation and point to further declines ahead. Similarly, though wage growth remains high, it has reliably lagged the Harmonised Index of Consumer Prices inflation by a year, suggesting wage pressures should continue to moderate and the risk of a wage-price spiral is low. Nonetheless, the last mile of normalisation will likely be bumpy. The fact that the ECB raised their near-term growth and inflation projections indicates they will want to see further evidence that disinflation is continuing before delivering additional rate cuts.

Monetary easing should serve to foster the European economic recovery that began in first quarter 2024. This broadening out of economic growth beyond the United States should act as an earnings tailwind for DM small-cap equities, which have a greater cyclical tilt than the broad market. The prospect of a turn in the interest rate cycle should also aid the many small-cap firms that have struggled under the weight of higher rates, due to greater leverage and shorter debt maturities. This convergence of fundamentals can serve as the catalyst for narrowing the substantial valuation gap that currently exists between small caps and their larger peers. All told, this environment should be conducive to small caps repeating their historic tendency to deliver excess returns during economic recoveries and expansions.

Thomas O’Mahony
Senior Investment Director, Capital Markets Research

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Why Private Credit?

The private credit asset class benefits from several characteristics that we believe are attractive to investors’ portfolios. The asset class has a contractual maturity date, often benefits from collateral, and is senior to the equity in the capital structure. These attributes provide compelling downside protection and a shorter duration relative to private equity and venture capital.

Private credit has historically outperformed public leveraged finance asset classes such as BSL and high-yield bonds. As a private investment, the asset class exhibits less volatility than the publicly traded markets. While public and private credit marks will be driven by credit quality, public markets also include an element of supply/demand (market technical) that can cause mark-to-market price volatility. Depending on credit quality, private credit spreads tend to be 200 basis points (bps) to 600 bps higher than public markets (Figure 2).

Direct lending loans are floating rate, which have limited interest rate risk and help to protect a portfolio from rising rates. Loans will typically be structured with an interest rate floor, which will ensure a minimum level of income. Most strategies will distribute interest income quarterly, and, with an average life of three to four years, principal is returned at a significantly faster rate than private equity strategies. Additionally, with a contractual maturity date, private credit funds have shorter lives than other private investment strategies.

Relative to public markets, private credit strategies offer investors stronger alignment of interest. In the public markets, whether high-yield or BSL, underwriting banks have an originate-and-distribute model. In this model, the underwriting bank will view the borrower as their client, not the investor or holder of the loan. The motivation for the bank as intermediary is to obtain the best deal for the borrower that will clear the market. In private credit markets, the general partner (GP) is often the originator of the loan and the manager of the risk. The GP views the limited partner (LP) as its client, and its objective is to get the best deal possible for the fund.

Private credit strategies, particularly direct lending, benefit from downside protection through a number of contractual provisions. Financial maintenance covenants provide an early warning to deteriorating borrower performance, allowing for lender intervention and the ability to work with the company to influence an improvement plan. Lending on a first-lien senior-secured basis means that the direct lending loan is secured by assets of the company. In the event of a restructuring, private credit’s position in the capital structure means that it will receive a recovery before the equity. If the equity is worth anything greater than zero, then the direct lending loan will receive all its money back plus a return.

Private credit includes a diverse array of strategies allowing investors to build a portfolio of complimentary strategies. The section below reviews the sub-asset classes in more detail, but we believe that the diverse strategies available in private credit allow an investor to construct a portfolio that will be less correlated to equity markets and can produce stable, attractive returns.

Sub-asset Class Review

Figure 3 depicts how private credit strategies offer a range of return targets and fund lives.

Senior Debt

Senior debt, or direct lending, refers to funds that lend money to performing companies on a first lien senior secured basis. The loans will be used for a variety of purposes, including financing leveraged buyouts and acquisitions, funding growth, or repaying existing debt. The company may be owned by a private equity firm (sponsor-backed) or a public or privately owned company (non-sponsor-backed). Managers will tend to focus on company size, with lower middle market defined as companies with $10 million to $50 million of EBITDA; core middle market as companies with $35 million to $100 million of EBITDA; and upper middle market as companies with greater than $100 million in EBITDA. Sponsor-backed core middle market is considered the most competitive area of the market. Upper middle market competes with the BSL market, and, as such, tends to feature weaker terms and less favorable pricing.

The loans will generally be floating rate, based on the secured overnight financing rate (SOFR) plus a credit spread, minimizing interest rate risk, and issued below par to create original issue discount (OID). The loans will be secured by the assets of the company. The fact that the loans are generally secured by all the assets of the company is important as it impacts the recovery value. Historically, first-lien debt has an ultimate recovery value of 70%, while unsecured bonds have a recovery rate of 47%, according to Moody’s.

Senior debt funds may use fund level leverage to increase the capital available for investment in order to increase the returns. Leverage will generally be non-recourse to the LPs and will not be mark to market. The leverage provider could be a bank, another fund, or a structured finance vehicle such as a collateralized loan obligation. The debt used for this purpose will be secured by the loans owned by the portfolio and not by the obligation of the LP to fund a capital call. This is different from a subscription line, which is secured by the fund’s right to call capital from the LPs. Subscription lines do not increase the amount of capital available to invest but instead change the timing of the cash flows, which could increase the internal rate of return. Generally, private credit funds use subscription lines only to facilitate capital calls and will pay the lines down to zero periodically.

Subordinated Capital

Subordinated debt is a loan or security that ranks lower than other loans with regard to claims on assets or earnings. Subordinated debt is a riskier form of debt as it is not repaid until after unsubordinated (senior) debt holders have been repaid in full. Often called mezzanine debt because it ranks between the senior debt and the equity of a company, the debt will frequently include some form of equity, either a co-investment in the common equity alongside the private equity owner or warrants.

The subordinated capital category also includes capital appreciation strategies. These funds will invest, typically in performing companies, anywhere in the capital structure from senior debt to preferred equity. The debt investment will often include some form of equity upside, such as warrants, preferred securities, or in the common equity. As the demand for mezzanine debt has waned in recent years, many mezzanine debt managers have migrated to this strategy. In both traditional mezzanine and capital appreciation strategies, the returns are driven by both the debt security and the equity ownership. Typically, a subordinated capital fund will include between 10% to 20% equity exposure.

Credit Opportunities and Distressed

Credit opportunities refers to a broad range of strategies that are typically opportunistic in nature, meaning they are either investing in companies in stressed or distressed situations, or addressing an unmet capital need in a creative way. Credit opportunities funds may have a broad spectrum of credit and debt-related investments across geographies. Investments can be made in performing, stressed, or distressed companies, and can be directly originated and structured in the primary market or reflect purchases of securities in the secondary market. While the return of a credit opportunities fund will be focused on income, there will often be an element of equity return or capital gain, particularly in more distressed situations.

Credit opportunities managers may pivot to a greater focus on distressed when market default rates rise to elevated levels. Some managers are exclusively focused on distressed situations. Distressed investors target companies or assets where the company is at a high risk of entering bankruptcy or restructuring. While it is not the intent of the fund to own the company, the manager is prepared to take equity through a restructuring and own that equity for a period of time. This strategy differs from distressed for control strategies, where the explicit purpose of purchasing the debt security is to take ownership of the company through a restructuring of the debt. We view distressed for control as more of a private equity–type strategy, as the manager seeks to own and manage companies as its primary activity.

Specialty Finance

Specialty finance managers pursue a very broad array of niche strategies, requiring highly specialized expertise. A key feature of specialty finance strategies is that they provide diversification away from single name corporate risk—either by lending or investing in pools of assets—or investing in assets that are not correlated to equity markets. A common strategy is to lend against a pool of financial assets, such as consumer or small business loans. The fund is essentially funding the non-bank originator of the loans who may remain as the servicer of the loans. The loans are placed into a special purpose vehicle, which insulates the investment from distress at the originator as the loans can be moved to another servicer. The loan will be structured by looking at historical default and loss rates and requiring the originator to retain the first loss piece, or cushion, to the pool. This is similar to the process used to create asset-backed securities. Another common strategy is for the fund to own a portfolio of equipment, such as rail cars or aircraft, and lease the equipment to create a cash flow stream.

Other strategies include investing in royalties. In life sciences, managers may invest directly in the royalty, helping the company or other entity that owns the royalty to monetize its asset by allowing the fund to collect the royalty payment for a period of time. Similarly, in music royalties, the artist can monetize its catalogue by selling the royalty payments. Increasingly, life sciences managers have moved to a lending strategy where the patent is taken as collateral. This will shorten the duration of the investment. Additional strategies include life settlements, insurance, trade finance, litigation finance, and non-performing loans.

Specialty finance can have a wide range of return targets and duration depending on the strategy. Consumer lending tends to be very short, while royalties—particularly music royalties—can be very long dated. Returns can range from the high single digits to the high teens.

Implementation

With the variety of private credit strategies available, we believe it is possible to create a well-diversified portfolio that can generate income and provide some upside. We like to construct portfolios with a mix of senior debt, credit opportunities, and specialty finance strategies (Figure 4). Senior debt strategies generate cash flow and provide a ballast to the portfolio, offering downside protection and income. A credit opportunities strategy should generate returns higher than direct lending during benign markets, and, importantly, will benefit from market stress and dislocations. The funds can offset any stress that may be seen in the senior debt strategies during periods of elevated defaults. An allocation to specialty finance will provide diversification away from single name corporate risk.

When constructing a portfolio, an investor’s primary objective will influence allocation to the different sub-strategies. For example, an income-oriented investor may focus on direct lending strategies, picking a diversified group of managers to gain exposure to sponsor and non-sponsor and across the borrower size categories. This portfolio may also consider an allocation to income focused specialty finance strategies to provide some diversification. The portfolio should provide a stable income stream, 100 bps to 200 bps higher than the public leveraged finance markets, with lower volatility and risk profile.

Investors more focused on returns will gravitate to higher returning strategies in credit opportunities and distressed. Strategies may focus across different asset classes, such as corporate, real estate, and structured products. A portfolio constructed this way could be attractive to a tax-paying investor, as it can focus on strategies that offer a greater degree of capital gain relative to income.

Investors seeking a diversified allocation to private credit may invest across the different sub-asset classes, such as senior debt, credit opportunities, and specialty finance. We believe that a portfolio constructed this way can deliver an attractive income stream, coupled with some higher returning credit opportunities strategies that can also benefit from a dislocation. The addition of specialty finance will serve to diversify away from corporate risk. Investors can weight the components depending on their preference for income relative to higher returning strategies.

Investors allocate to private credit from various parts of their portfolios. Some investors will have a specific allocation to private credit as part of their total portfolio. Investors that allocate from their illiquid buckets will often focus on higher returning strategies as they are comparing the funds to their private equity and venture allocations. In a zero-rate environment, many investors looked to direct lending to improve returns in their fixed income allocations. Finally, many investors have looked to their diversifiers bucket to carve out a piece to allocate to private credit, recognizing that the lock-up nature of the funds is illiquid relative to the rest of that allocation, but that the private credit portfolio can generate some income and an attractive return.

Conclusion

The private credit market has developed and evolved significantly since the GFC. The asset class includes a broad array of strategies to satisfy investors’ return objectives. Strategies can be cash flow generating and offer shorter duration than other private investment strategies. Downside protection creates an attractive risk mitigant relative to private equity and venture strategies. Investors can construct portfolios to provide income, benefit from market dislocations, and provide some diversification away from single name corporate risk.

Frank Fama, Co-Head of Global Credit Investment Group

Walker Haymond, Brittney McManus, and Ilona Vdovina also contributed to this publication.

Index Disclosures

Bloomberg Aggregate Bond Index
The Bloomberg Aggregate Bond Index is a broad-based fixed income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.

Bloomberg US Corporate High Yield Index
The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high-yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on the indexes’ EM country definition, are excluded. The US Corporate High Yield Index is a component of the US Universal and Global High Yield Indexes. The index was created in 1998, with history backfilled to July 1, 1983.

Bloomberg US Treasury Index
The Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting. The US Treasury Index is a component of the US Aggregate, US Universal, Global Aggregate, and Global Treasury Indexes. The index includes securities with remaining maturity of at least one year. The US Treasury Index was created in March 1994, and has history back to January 1, 1973.

Morningstar LSTA US Leveraged Loan 100 Index
The Morningstar LSTA US Leveraged Loan 100 Index is designed to measure the performance of the 100 largest facilities in the US leveraged loan market. Index constituents are market-value weighted, subject to a single loan facility weight cap of 2%.

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The rallies in both bitcoin and gold since last fall have certainly been noteworthy. Bitcoin fervor has returned, owing to two factors. First, the SEC approved spot bitcoin ETFs in January, making it easier for investors to access and triggering significant investment inflows. Second, the anticipation of bitcoin’s fourth “halving” event, which will decrease the rate of new bitcoins entering circulation, sparked speculation that the fair value of bitcoin exceeds its recent price. The digital currency reached $73,000 by mid-March, surpassing its November 2021 high. It climbed 190% trough-to-peak since its September low, representing the ninth time that bitcoin has seen a price increase of more than 100% without a significant price reversal during the run-up. ¹

Gold’s surge has been driven by geopolitical tensions, an uptick in central bank purchases of gold, and the decline in the US ten-year Treasury yield. On the latter, the US ten-year Treasury yield has declined by roughly 70 basis points to 4.3% since mid-October, which has decreased the opportunity cost of holding gold. As a result, gold gained 10% over that same period and is currently near an all-time high of just under $2,200/troy ounce. This has been a sharp rally by gold’s standards.

But focusing on prior rallies is only half of the story. After each of the prior eight episodes when bitcoin gained more than 100%, it experienced a median drawdown of 30%, which often happened in less than a month. It is also worth noting that bitcoin plummeted 77% in just over one year after reaching its last peak of around $68,000 in 2021. Gold’s drawdowns have been fewer and smaller in magnitude. Still, since 1990, it has seen nine drawdowns with a median of -22%, and these drawdowns occurred after gold had rallied by around 40%.

Still, we view bitcoin and gold as different investments. We see bitcoin as highly speculative, and we believe it will behave like other risk assets in a market downturn. In contrast, gold has a more proven track record as a reliable haven instrument, meaning it may perform well in a risk-off scenario.

All this is to say that these rallies in bitcoin and gold may be overextended when viewed with a historical lens. At the very least, investors choosing to add either asset should size positions modestly, understanding that rapid price swings are likely to persist. Recent price action in bitcoin furthers this point; in the week since it reached its all-time high, it saw a 15% pullback in its price. For those investors thinking of adding gold as a potential source of portfolio protection, we favor long US Treasury securities, which also offer that benefit and include the added bonus of a healthy yield.

Sean Duffin, Senior Investment Director, Capital Markets Research

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.

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Global inflation fell sharply in 2023. One broad measure of G7 economies indicates inflation fell to 3.1% year-over-year in November 2023, down from 7.3% one year earlier. So far, the decline in inflation has been primarily driven by lower commodity and goods prices, which have come down due to a normalization of supply chain disruptions. Services inflation has been slow to moderate and, given recent shipping disruptions in the Red Sea, some have wondered whether inflation may again accelerate. We doubt it.

Shelter prices were one of the biggest contributors to sticky services inflation in 2023, particularly in the United States. US shelter prices rose 6.2% over the last year in December, accounting for more than two-thirds of the 3.9% increase in US CPI excluding food and energy (i.e., core CPI). Elevated shelter prices have led to a divergence between two key measures of inflation, core CPI and the core Personal Consumption Expenditures (PCE) Price Index, the Federal Reserve’s preferred metric. The latter has a much lower weight to shelter and rose just 2.9% year-over-year in December, which is a full percentage point less than core CPI! In fact, core PCE is below the Fed’s 2% target over the previous six months. Further, real-time indicators of rental prices, such as the New Tenant Rent Index, point to a steep decline this year in shelter inflation, which is itself a notoriously lagging indicator.

The trend in core services ex shelter prices, or “super-core” inflation, also appears to be headed down. Prices of these services are closely monitored by central bankers as a signal of cyclical inflation because of their tight relationship with labor market conditions. Resilient growth and tight labor markets supported wages and the prices of some core consumer services in 2023. This likely isn’t sustainable. Tight monetary policy and fading consumer tailwinds (e.g., a decline in excess savings) both point to a more challenging growth environment going forward. Analysts project real GDP will expand just 1.5% in the United States, 0.5% in the Eurozone, and 0.3% in the United Kingdom this year. And while labor markets are tight, they are softening. For example, a decline in US job openings and quit rates has already put downward pressure on wages. The US Employment Cost Index rose by a relatively weak 0.9% in fourth quarter 2023. The anticipated downshift in economic growth should accelerate this process and, in turn, pull down wages and super-core inflation.

As previously mentioned, the initial fall in inflation has mostly been driven by the normalization of supply chains. This process is now mostly behind us. The latest reading of the Fed’s Global Supply Chain Pressure Index is back in line with its historical average after spiking during the pandemic. However, lower commodity prices, stable input costs, and an expected downshift in global growth all suggest goods categories will likely continue to be a source of disinflation. Recent shipping disruptions in the Red Sea have led to an increase in global freight costs and a marginal deterioration in supplier delivery times. However, the disruption to date pales in comparison to the pandemic and the broader price impact appears modest.

Major central banks in recent months have opened the door to the possibility of cutting interest rates in response to the accelerated decline in inflation. Central bankers face two-way risks as they attempt to appropriately calibrate the timing and magnitude of cuts. Wait too long, overtighten, and cause a recession, or ease too much, too soon, and cause inflation to reaccelerate. In our view, the broad trend in inflation remains down and this calls for most global central banks to at least modestly lower policy rates this year. The combination of lower inflation and policy rates should pull Treasury bond yields down across the curve and cause yield curves to steepen. As such, we continue to recommend a tactical overweight to US long Treasuries.

TJ Scavone, Senior Investment Director, Capital Markets Research

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.

The post Will There be a Second Wave of Inflation? appeared first on Cambridge Associates.

New Dynamics, Old Strategies?

Plan sponsors today are operating in the aftermath of one of the fastest rate hikes in history and a prolonged yield curve inversion. Discount rate increases, along with strong equity performance since the March 2020 COVID-19 bottom, have powered significant improvements in funded status (Figure 1). These factors have proven especially beneficial to plan sponsors with underfunded and underhedged plans, helping them catch up with those that have spent the past decade contributing to their plans and increasing their liability-hedging targets.

Most DB plans today also have much improved risk profiles. Funding relief regulations such as MAP21 ² and ARPA ³ have stabilized the interest rates used for determining plan contributions and lengthened the time periods available to plans for addressing funding shortfalls (Figure 2). These measures have helped to make funding more predictable over the long term by using a moving average yield to determine funding requirements. As a result, pension plans have much lower contribution risk as compared to two decades ago. Even with the steep rise in discount rates devaluing some of the cost savings from these regulations, it is still important for plan sponsors to recognize that these changed dynamics are likely here to stay. What’s more, they may need to reconsider how they manage their plan to remain on track for long-term success.

Shifting Gears

Plan sponsors have four key levers to manage their pensions—asset returns, liability hedges, contribution policy, and benefit management (Figure 3). While these levers do not change over time, how they are operated should, as plan sponsors look to remain on track with plan goals and objectives. Whether a plan is recently closed, frozen, or open, the observations we share below are broadly applicable to ensuring its optimized management.

Growth Assets: Meeting New Goals Amid New Risks

Although many plans today are well funded and well hedged, growth assets remain a critical component of overall plan health, helping to offset administrative expenses, unfavorable demographic trends, actuarial assumption changes, and other unhedgeable aspects of liabilities. As later discussed in the benefits management section of this paper, a properly executed growth strategy can also increase a plan’s overall value to an enterprise by reducing the cost of retirement and other employee benefits and by funding other organizational priorities.

Even though many plans have been focused recently on investing in a higher interest rate environment, these allocations alone may not provide adequate diversification in the event of market volatility. This volatility could be driven by multiple variables, including additional interest rate changes, an economic recession, increased pressure in the banking sector, heightened geopolitical tensions, or any black swan event.

Private credit, high-yield fixed income, hedge funds, and real assets are all strategies with the potential to help enhance diversification, provide downside protection, and achieve superior returns. Of these strategies, private credit can be particularly advantageous. Higher yields, coupled with a floating rate structure, may prove beneficial in a rising rate environment, with some strategies providing risk mitigation due to senior standing in companies’ capital structure. As with any private asset class, however, conducting robust due diligence will help achieve superior returns and avoid strategies that appear favorable on the outside but may contain hidden risks on the inside, such as subpar lending standards, poor execution, and unfavorable deal flow.

As plan sponsors evaluate their growth-oriented options, they should validate their true liquidity needs. Doing so may enable them to unlock their portfolio’s full growth potential by using excess liquidity to take advantage of opportunities in higher return, generating private equity investments (Figure 4). A liquidity coverage ratio of 2x to 3x can help ensure a portfolio is positioned to tolerate periods of market stress.

The liquidity risk of private investments in a pension portfolio varies depending on its net cash flow. As net distributions increase, the optimal allocation to private investments decreases (Figure 5). Partnering with experts in the private investment space is crucial to understanding the implications of these cash flow dynamics. The days of investors shooting in the dark to build out private investment allocations are over, as data and technology improvements make it easier to analyze liquidity requirements in an asset/liability context.

Liability Hedging: Less May Be More

Many plan sponsors have been highly focused on increasing long-duration liability-hedging assets in recent years. However, it may be time to reconsider how to manage liability risk going forward, including the appropriate amount of capital committed to these strategies and the optimal mix of credit duration. As always, a plan’s liability-hedging strategy is informed by its funded status. It follows that improvements in funded status should inspire a revised approach to liability hedging. As plan sponsors consider their options in today’s investment landscape, they now have a better set of tools at their disposal.

For example, because the accounting discount rate for single-employer pension liabilities is based on the Aa yield curve, a portfolio of duration-matched bonds can provide a good hedge against interest rate volatility. The earlier use of a completion manager may also help to keep higher hedging ratios, while also freeing up capital to implement more effective credit risk management and achieve additional exposure to growth assets.

It’s important for plan sponsors to recognize that the old paradigm of devoting the vast majority of plan assets to liability hedging should evolve into a more balanced approach. In fact, with liability durations decreasing relative to many fixed income assets today, more hedging can be achieved with fewer dollars. Less commonly used investment strategies, such as intermediate credit, also can play a role here. They can offer multiple potential benefits, including increased yields, liability carry offset, and better credit curve exposure, which in turn can result in lower volatility and higher returns.

Plan sponsors should also evaluate the overall fit and relative importance of liability hedging for their plans. There is now diminishing marginal utility in hedging the “last-mile risk” in pension portfolios with more capital. In some cases, an excessive hedging effort may result in a lower returning liability-driven investment (LDI) program, which decreases the efficiency of not only the liability-hedging assets, but the entire portfolio. Instead, plans may pick up incremental yield by adding non-traditional instruments for hedging, such as private investment-grade credit, commercial mortgage loans, and securitized assets. This may help the liability-hedging portfolio keep pace with the higher interest cost on liabilities, while still reducing interest rate risk through completion or other Treasury strategies. Figure 6 depicts how allocating only 30% of the liability-hedging portfolio to more diverse hedging assets can result in 50 basis points of extra annual yield.

For plan sponsors whose main objective is controlling or minimizing contribution requirements, hedging liabilities may introduce additional risk. In this scenario, plans should consider blending total return investment approaches with specialized liability-hedging programs to achieve the optimal outcome. The recent rise in discount rates has also presented a new option—adjusting contribution requirements to be based on mark-to-market liabilities. This option allows a liability-hedging program to not only reduce accounting funded status risk, but also contribution risk.

Contributions: A New Paradigm

Even if plans should experience negative asset returns in the near term, they can afford to be less concerned about contribution volatility due to the favorable impact of regulatory changes on funding target ⁴ calculations. The significant funding relief options passed in the last decade have resulted in the adoption of higher interest rates for minimum required contribution calculations. For example, plans are allowed to discount liabilities using 25-year moving average rates, which are then bound by interest rate corridors. When higher discount rates are used, liabilities are lower, which leads to higher funded status and lower contribution requirements.

In addition, due to new shortfall smoothing rules, a decline in funded status will no longer result in exceedingly high mandatory contributions. This changed regulatory backdrop, coupled with revamped asset and liability management options, effectively lightens the load for plan sponsors, potentially freeing up corporate assets for other purposes, including critical enterprise goals.

Contribution risk should generally be considered separately from funded status risk, since the duration for liabilities used to determine contribution requirements is essentially zero. While the use of long-duration fixed income strategies is beneficial to hedge long-duration accounting liabilities, it has a countereffect for liabilities with zero duration. While this wasn’t much of an issue when interest rates were low, the disparity is presenting a bigger opportunity in today’s higher interest rate environment. Well-hedged plans can consider aligning accounting and funding target methodologies through the Full Yield Curve approach, which may not only reduce expected contribution requirements, but eliminate much of the contribution volatility risk.

Underhedged plans should be more cognizant of the difference and focus on controlling the risk that is most important for them—balance sheet or contribution volatility. Even under the stabilized interest rate approach, certain aspects of pension management, such as Pension Benefit Guaranty Corporation (PBGC) premiums, are sensitive to interest rate changes. The most risk-efficient plan portfolios often blend traditional investments with LDI strategies in accordance with plan sponsor objectives and circumstances.

Benefits Management: Reassessment Required

Multiple benefits management approaches are always available to plan sponsors. These include plan termination, hibernation, partial risk transfer, future benefit modification, maintaining an open plan, or even re-opening one. Each of these approaches carries direct and indirect costs and risks. A close consideration of the plan sponsor’s specific needs and goals will help determine the right way forward.

Many plan sponsors can evolve their DB plans from feeling like a burden to feeling like an asset, one that supports corporate goals and financial health. Thanks to effective benefit management—combined with more supportive plan regulations and tools for generating asset growth and managing liabilities and contributions—plan sponsors are able to extend the life of their DB plans. Well- and over-funded pensions can become a point of differentiation for these enterprises and a valuable tool in attracting and retaining talent for the organization. Surplus plan assets also can be used in other ways that are long-term value additive to an organization, including mergers & acquisitions activity and retiree medical benefits. As plan sponsors consider a DB plan restart, expansion, or extension, they are likely to find that DB plans come at a marginal cost compared to defined-contribution plans. In fact, the National Institute on Retirement Security estimated that a DB plan costs 27% less than an “ideal” defined-contribution plan—one with fees below the industry average delivering strong performance. ⁵

Those sponsors closer to the termination side of the spectrum should consider how they can approach de-risking economically. For instance, many lean toward offering a lump sum payment option to plan participants; in this scenario, participants who receive a payment are no longer due a benefit from the plan. While this seems routine enough, it is important that payments be apportioned strategically so they result in less assets transferred than the liability. Generally, cost savings occur during declining interest rate environments that generate a lower lump sum payment relative to the market-to-market liability. However, this strategy can backfire in a rising rate environment and result in many plan sponsors having to contribute capital in order to terminate as lump sums become more expensive than buying annuities. Similar issues can occur for plans opting for pension risk transfers (PRTs) via lump sum windows.

Partial PRTs are commonly used with the idea of reducing plan size for purposes of PBGC premium savings. However, for most underfunded plans, this kind of transaction may actually negatively impact funded status and increase plan costs and PBGC premiums over the long term—even if the amount of assets transferred is less than the liability (or a gain to the plan). All sponsors should fully understand the implications of PRTs in terms of funded status, risk reduction, and future costs for their plan. For many plans, managing risk through asset allocation decisions is more effective.

Achieving a surplus position is never easy or risk free—and may be prohibited by many glidepath designs, especially those that aim to lock in funded status at a point just above 100% funded. For this reason, plan sponsors should reconsider the end stage of their glidepath, given the utility of a surplus and the potentially higher funded status needed to terminate without cost if a previous PRT has already been performed. Plan sponsors wishing to use surplus assets may find that increasing allocation to growth strategies could be advantageous as the plan moves higher in funded status, with the notion that the further away the plan is from becoming underfunded, the more risk a plan can take in pursuit of higher surplus.

Adaptability Is Key

Although pension plans today are experiencing much improved funded status relative to years past, the extent to which they take advantage of the opportunities made available by favorable improvements in funding and regulations will be a key determinant of their future health.

In all market conditions, the four levers that plan sponsors control as they seek to accomplish their objectives remain the same. However, an informed, adaptive approach to the operation of each will help ensure continued plan success over the near and long term. Plan sponsors are strategizing for growth and managing risk in in a significantly different investment environment. To accomplish their goals, it is imperative that these changes be taken into consideration. By taking a fresh look at their investment strategies and plan management, organizations have an opportunity to adapt, evolve, and reap significant benefits.

Serge Agres, Managing Director, Pension Practice

Cathy Xu, Investment Director, Pension Practice

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
3. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
4. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
5. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

The post A Changed Investment Landscape Is Providing Greater Opportunity for US Corporate Pensions appeared first on Cambridge Associates.

Most Major Central Banks Should Cut Rates in 2024

TJ Scavone, Investment Director, Capital Markets Research 

Global central banks have aggressively tightened monetary policy to beat back inflation. While monetary policy now appears to be in restrictive territory, it is still too early to declare victory. Inflation rates are falling, but remain elevated. However, we expect restrictive policy will continue to weigh on economic activity and, in turn, inflation in 2024. This will ease pressure on central banks, which we expect will lead to modest policy rate cuts by year end.

After two successive years of tightening monetary policy, most major central banks currently view policy as appropriately restrictive. Financial conditions have tightened, and inflation globally has fallen considerably from its recent peak. As a result, many central banks are considering pausing tightening and the market consensus projects most central banks will modestly cut rates in 2024. Still, several central banks have suggested rates will need to remain “higher-for-longer,” increasing uncertainty around interest rate forecasts.

In our view, consensus expectations of policy rates are reasonable. Inflation may be elevated, but it is in a downward trend. Global economies have thus far held up better than anticipated, but there are pockets of weakness, particularly in Europe. Even in the United States, which has been more resilient than other economies, some measures of activity are weakening. For instance, US jobs growth has slowed and the unemployment rate has ticked up from a low of 3.4% to 3.9%. Higher rates and reduced fiscal support will add to downward pressure on growth, which should lead to additional softening in the labor market, wages, and inflation.

With inflation moving closer to central banks’ price targets and labor markets showing clearer signs of softening, central banks will be inclined to modestly ease policy rates in 2024 to avoid overtightening. The Fed is projected to cut rates by roughly 100 bps in 2024. This would be only slightly more than previous “soft landings” in the United States. If growth concerns mount, both inflation and rates could fall more than is currently expected.

US Long Treasury Securities Should Outperform Cash in 2024

TJ Scavone, Investment Director, Capital Markets Research 

US Treasuries are in a historic slump. While performance has been better in 2023 than the prior couple years, US Treasuries are barely on track to finish up for the year and underperforming cash for the third consecutive year. However, in our view, the worst is behind us. We expect US long Treasuries will outperform cash in 2024, given our economic outlook, our view that the bond sell-off is overdone, and the fact that current yields look attractive compared to economic fundamentals.

The bond sell-off clearly appears overdone. This was also the case in fourth quarter 2022, and ten-year US Treasury yields were recently as much as 75 bps above their 2022 peak. Unlike 12 months ago, many of the drivers of the sell-off are currently reversing. For instance, US inflation is declining. Core consumer price increases (4.0%) are still elevated, but the deviation from target is almost entirely due to shelter price rises, which are expected to decelerate in the coming months. The US economy has been resilient, but momentum appeared to peak in third quarter 2023, and weaker growth is forecast in the quarters ahead. If consensus is correct, nominal GDP growth for 2024 will fall below its trailing ten-year average, a trend that is usually consistent with lower Treasury yields.

A “soft landing” would reduce the risk of additional rate hikes. It also makes it more likely the Fed will keep its policy rate elevated for longer. However, this is mostly priced in. The Fed is projected to cut rates by roughly 100 bps in 2024, which is only slightly more than the number of cuts during previous soft landings. In sum, there is limited risk from further rate hikes, little to no risk from a soft-landing, but significant return upside for long Treasuries if growth concerns mount and the Fed cuts rates more than expected.

Another key difference is that yields look more attractive today. Ten-year US Treasury yields recently peaked above 5.00%. That is more than 1 standard deviation above their implied fair value based on economic fundamentals. Since 1973, the Bloomberg US Long Treasury Index has outperformed cash by 11 ppts on average over the next 12 months when this threshold is met, with a 90% probability of a positive excess return. We like those odds.

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
3. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
4. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
5. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

The post 2024 Outlook: Interest Rates appeared first on Cambridge Associates.

US High-Yield Bonds Should Outperform Loans in 2024

Wade O’Brien, Managing Director, Capital Markets Research 

Leveraged loans are on track for their third consecutive year of outperformance compared to US high-yield (HY) bonds for the first time in more than 20 years. This is unlikely to continue in 2024 as leveraged loans face greater headwinds from slowing economic growth and rising debt servicing costs.

Rising short-term yields have boosted loan coupons and returns but hurt issuer fundamentals. Loan interest coverage ratios have dropped from 4.4x at the end of 2022 to 3.0x at the end of third quarter 2023 and are even lower once expenses, such as maintenance capex, are considered. Ratios look even shakier for the weakest borrowers that have driven recent performance. B- rated borrowers have a coverage ratio of less than 2x. US loan default rates (3.1% over the past 12 months) already outpace those of bonds and higher rating downgrade ratios suggest this will continue. Further, weak loan documentation and an increasing share of loan-only issuers mean these defaults will continue to prove more painful for investors.

In contrast, HY index coverage ratios have also declined but remain much higher (around 5.0x as of mid-year). Much smaller HY index weights for lower rated (B- and CCC) issuers are one explanation. Looking forward, the gap between HY and loan issuer fundamentals should widen as the impact of higher short-term rates continues to be reflected in loan issuer borrowing costs.

While we think HY bonds will outperform loans in 2024, we remain neutral overall, given current spreads are below their historical average and levels typically seen during recessions. HY defaults are likely to rise, especially if growth disappoints in 2024. Loan defaults also could prove manageable if weak covenants provide companies more cushion and/or private equity owners step in to provide support. Given these dynamics, our preferences in liquid credit remain for securitized assets like investment-grade collateralized loan obligation debt, where yields are in mid-to-high single digits and elevated spreads provide cushion if issuer fundamentals deteriorate in 2024.

Direct Lending Strategies Should Deliver Above-Average Returns in 2024

Frank Fama, Co-Head of Global Credit Investment Group

After a decade-plus era of cheap money, the higher-rate environment will continue to directly benefit the floating-rate direct lending asset class. Direct lending strategies tend to provide steady cash flows, generate consistent returns, and distribute capital at a faster rate than other private investment strategies, particularly in today’s environment. We expect that direct lending strategies will deliver returns above the long-term average of 6% to 7% for unlevered funds and 8% to 10% including fund level leverage, given attractive current yields and solid underwriting standards.

Direct lending funds provide first-lien senior-secured loans to middle-market companies. These loans are typically floating rate and had a yield of around 7% when rates were low. Currently, with three-month secured overnight financing rate roughly 550 bps and credit spreads around 600 bps, investors are enjoying low double-digit asset yields. Direct lending funds will distribute that income quarterly.

Loans structured in the current environment are more favorable to lenders than in the recent past. In a higher-rate environment, debt capacity of borrowers is lower, meaning leverage levels have come down and sponsors are contributing more equity to transactions. Financial covenants are being set tighter, helping to protect downside if the borrower underperforms. Additionally, loan funds will have a shorter duration than other private investment asset classes. Loans will typically have a maturity of five years and an average life of three to four years, so distributions to LPs will begin shortly after the end of the investment period.

Direct lending strategies have grown significantly over the last ten years amid a period of low interest rates and a strong economy, leading to low defaults. This has resulted in a period of little dispersion in returns. While today’s attractive all-in yields are an opportunity for lenders, they also increase borrowers’ interest expenses and potential risk. We expect that managers with experience across credit cycles and the discipline to maintain underwriting standards will differentiate themselves from the pack.

European Opportunistic Private Credit Funds Raised in 2024 Should Deliver Above-Average Returns

Vijay Padmanabhan, Managing Director, Credit Investments

European credit opportunities funds have returned an underwhelming 7.0% since mid-2011 against a targeted return in the mid-teens. A decade of near-zero interest rates gave corporates easy access to low-cost capital and allowed them to build strong balance sheets. Except for short periods of market dislocations or isolated cases of stress, it was mostly a challenging time for funds that specialize in providing highly structured customized solutions to balance sheet problems. But we believe this is set to change in 2024, as we expect corporates to actively look for ways to reduce interest costs and improve liquidity.

With interest costs almost doubling and operating costs remaining high, we have started to see a decline in key coverage ratios. One key metric, EBITDA-to-interest expense ratio for European buyouts, has fallen from 4.3x in 2022 to 2.5x in 2023. This goes to show the declining level of cash generation by corporates due to the rise in costs. We are likely to see more dispersion in credit with companies in certain sectors and geographies facing more pressure than others.

Since 2022, the pace of public market debt issuance has slowed, and European banks have pulled back to focus on their regulatory capital requirements. We have seen the commercial real estate market come under immediate pressure post-COVID. Pockets of distress are emerging in sectors, such as financial services and healthcare, as pandemic- induced financial support has waned. Credit strategies that can provide capital solutions to larger corporates that otherwise would have accessed public market and/or that can pivot into distressed opportunistically will see a robust deployment environment in 2024. While individual manager performance will, of course, vary, we expect next year’s vintage of European opportunistic private credit managers will deliver above-average returns.

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
3. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
4. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
5. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

The post 2024 Outlook: Credit appeared first on Cambridge Associates.