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8 ways pension plan investors can enhance yield to meet investment yield requirements

Institutional investors and pension plan consultants need to get the most out of their investment dollars. How do investors meet their investment yield requirements and future obligations?

We have identified eight strategies asset managers can potentially employ to meet pension obligations.

1. Long Duration Bonds
2. High Yield Bonds
3. Private Placements
4. Commercial Mortgage Loans
5. REITs
6. Dividend Paying Equities
7. Master Limited Partnerships
8. Options

1. Long Duration Bonds

One way a pension portfolio can enhance its yield is to invest in longer duration bonds.

Duration risk is the risk associated with the sensitivity of a bond’s price to a change in interest rates. The longer a bond’s duration, the greater its likely yield, and the greater its sensitivity to interest rate changes. This means fluctuations in price, whether positive or negative, will be more pronounced.

Examining the duration of a bond, bond fund or bond ETF can provide an estimate of how sensitive a portfolio may be to a potential change in interest rates. For example, when interest rates move by 1%, a bond with a 5-year duration would see its value change by approximately 5%. The duration of a U.S. Treasury bond with a 30-year maturity is approximately 20 years; a 30-year corporate bond has a duration around 18 years. Thus, under a 1% interest rate move, these bonds would see their market values change by about 20% and 18%, respectively.

Pension investors who are getting a simple 60/40 portfolio may likely have an asset duration that is shorter than their liability duration, so lengthening duration is a “free” yield pickup.

The chart below demonstrates that 30-year U.S. Treasuries have generally but not always generated between 0.5% and 1.5% more yield than 10-year U.S. Treasuries since 1977.

30-year Treasury Yield vs. 10-year Treasury Yield Spread

Yield spread of 10-year Treasury vs 3-year Treasury

Bloomberg. As of 12/31/2018. 30-Year Treasury Yield vs. 10-Year Treasury Yield Spread. See additional disclosures at the end of the materials.

2. High Yield Bonds

Investing a portion of a pension portfolio in high yield bonds may also, as the asset category name suggests, provide higher overall portfolio yields. For a historical illustration of the potential spread pickup of high yield bonds over investment grade bonds since 1994, see the chart below. We show the Bloomberg Barclays High Yield Index vs. the Bloomberg Barclays Investment Grade Index.

Note that the high yield category is typically shorter duration; high yield issuers come to market in the “5 years to maturity” range. The overall investment grade corporate index is closer to 10 years to maturity. The historical yield pickup really is therefore not a duration play; it is a judgment on creditworthiness and risk factors—business cycle risk, interest rate risk, and sector or issuer risk.

High Yield vs. Investment Grade Bonds Yield Spread

High yield versus investment grade bonds yield spread

Bloomberg. As of 12/31/2018. High Yield vs. Investment Grade Bonds Yield Spread. See additional disclosures at the end of the materials.

3. Private Placements

Private placement bonds offer the potential for enhanced yields—and can increase diversification by accessing companies not available in the public market.

Relative to public corporate and municipal bonds, private placement bonds offer: covenants, which provide downside protection and potential for additional fee income; incrementally higher coupon rates; and diversification through exposure to borrowers that typically do not participate in the public debt markets.

The asset class has proven to be durable in a variety of market conditions and is best suited for pension investors who have strong legal and credit underwriting skill sets, along with long-standing market relationships.

The incremental yield for private placements has traditionally compensated investors for the perceived lack of liquidity relative to public bonds.

The historical yield spread between private placements and public credit has been noticeable. For example, the spread between private placements and U.S. Treasuries was around 300 basis points (bps) in 2009. The spread of public credit was more like 200 bps. This translated into real yields of approximately 7% and 6%, respectively, for private placements and public credit. By going to private placements, investors may pick up the spread advantage beyond public credit depicted in the following graph.

Yield advantages of Private Placements

Yield advantages

As of 12/31/18. Source: Securian AM. See Private Placement Acquisition Spreads Disclosure in Appendix. Private spreads represent an average for all securities purchased by Securian AM during the calendar year and public spreads refer to the sector-specific (FIN, IND and UTIL) Factset-derived daily matrices beginning 09/01/18, and to the Merrill Lynch U.S. Corporate Master Index-derived spread matrix for the periods prior to 09/01/18. Spreads are the difference between a private placement security or public security and a government security of comparable duration.

4. Commercial Mortgage Loans

Investing a portion of a pension plan’s assets in a portfolio of commercial mortgage loans may also enhance yield. As of December 31, 2018, the yield advantage — the difference between the commercial loan yield in, for example, Securian AM’s Commercial Loan Portfolio and the BBB Industrial 7-year yield — was 1.40%. The historical result has been similar to getting BBB-bond yield for Single-A credit quality. See chart below:

Commercial Real Estate Loans Yield

Bbb graph

Securian AM Commercial Mortgage Loans as of 12/31/2018 (updated annually). Commercial Mortgage Loan Yield represents the gross current bond equivalent yield (BEY) of the Securian AM Commercial Mortgage Loans for this period. Commercial Mortgage Loan yield is net of fees, except Securian AM servicing fee. The “A” Industrial 7-year index includes industrial sector fixed income securities rated A with a 7-year duration, as defined on Bloomberg under the code C0067Y. Yield advantage represents the difference between the Commercial Mortgage Loan Yield and the “A” Industrial 7-year yield. The index is unmanaged and is not subject to fees and expenses. Investments cannot be made directly into an index. See additional disclosures at the end of the materials. Past performance is no guarantee of future results. Lending involves many inherent risks. Loans can lose value, including the potential loss of the entire loan.

5. REITs

A diversified portfolio of income-producing real estate securities can boost the yield of a pension plan portfolio. Real Estate Investment Trusts (REITs) typically pay high dividends — by law, REITs must pay out at least 90% of taxable income as dividends each year.

REITs, common stock of public REITs and real estate related securities across multiple industry sectors can therefore potentially add both income and diversification to a traditional equity income portfolio.

The dividend yield of the FTSE NAREIT Equity REITs Index as of December 31, 2018, was 4.60%.

By contrast, the dividend yield of the stocks in the S&P 500® Index as of year-end 2018 was 1.83%.

6. Dividend Paying Equities

Not all stocks pay dividends, and not all dividend-paying stocks pay the same. Some stock categories, such as utilities, have historically paid more dividends than others. Some might be appropriate for a more dividend-focused equity allocation within a pension plan.

See below for the relative historical dividend yields, versus the unmanaged S&P 500® Index, for four key investment categories—REITs, utilities, MLPs (Master Limited Partnerships) and “Dividend Aristocrats.” The S&P 500 Dividend Aristocrats Index is a list of companies in the S&P 500® with a track record of increasing dividends for at least 25 consecutive years. It tracks the performance of well-known, mainly large-cap, blue-chip companies.

Dividend Yield relative to S&P 500®

Dividend equity

Bloomberg. As of 12/31/2018. High Yield vs. Investment Grade Bonds Yield Spread. See additional disclosures at the end of the materials.

7. Master Limited Partnerships

MLPs, short for Master Limited Partnerships, are typically in the energy sector (e.g., pipeline companies) and pay large dividends because they are legally required to do so. MLPs have historically paid the highest yield compared to other equityoriented investment selections.

A master limited partnership combines the tax benefits of a limited partnership (the partnership does not pay taxes from the profit — the money is only taxed when unit-holders receive distributions) with the liquidity of a publicly traded company. In order to qualify as an MLP, a firm must earn 90% of its income through activities or interest and dividend payments relating to natural resources, commodities or real estate.

Please refer to the chart above for the historically higher yields produced by MLPs.

8. Options

Investing in options is an additional strategy that pension plan asset managers can employ to enhance yield.

The yield from an option strategy, which is generated from the option premium received, can incrementally enhance portfolio income. The level of income is dependent on many factors, including the volatility in share price anticipated for the underlying stock, the level of the option exercise price and how far it is from the current share price, time to expiration and the current interest rate level — the lower interest rates are, other things being equal, the lower the option premium received.

About Securian Asset Management

Securian Asset Management, Inc. (Securian AM), is an institutional asset manager specializing in public and private fixed income, commercial real estate debt and equity with more than $38 billion under management as of December 31, 2018. The asset manager was established in 1984 and traces its history to the founding of parent firm Securian Financial Group in 1880.

Securian AM provides a breadth of customized liability-driven investment solutions that seek to exceed liability return requirements while managing funded status volatility within pension plan risk appetites. We design customized institutional investment solutions to help clients achieve their goals by using our long-standing asset allocation experience.

The author of this article, Craig Stapleton, CFA, FRM and Senior Vice President of Securian Asset Management, has 17 years of investment management experience.

About the author

Craig Stapleton, bio photo

Craig Stapleton, CFA, FRM
Senior Vice President, Portfolio Manager

Source is Bloomberg for all information, unless noted otherwise.

The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this article has been developed internally and/or obtained from sources believed to be reliable; however, Securian AM does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions and other information contained in this article are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and Securian AM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated.

Private Placement Acquisition Spreads Disclosure

The “Spread Advantage” row represents the average data for all securities purchased by Securian AM that provide a yield pickup to plain vanilla, public corporate bonds. For each year through 2008, this data includes all private placement securities and certain 144a structured securities purchased by Securian AM. The 144a securities were included because each security had a combination of one or more of the following characteristics that made them more similar to private placements rather than public bonds, lack of registration rights, collateral, covenants, non-DTC eligibility and/or amortization. Beginning in 2009, private placement securities include securities that are private placements only.

The data represents 10-year industrial public corporate bonds of comparable quality to those purchased by Securian AM during the same period. Years 2006 to 9/1/2018 are compared to the Merrill Lynch U.S. Corporate Master Index-derived spread matrix, in order to match term. The Merrill Lynch spread is an interpolation between maturities and credit quality. Public spreads refer to the sector-specific (FIN, IND and UTIL) Factset-derived daily matrices beginning 09/01/18 to present.

This material may not be reproduced or distributed without the express written permission of Securian Asset Management.

Securian Asset Management, Inc., is a subsidiary of Securian Financial Group, Inc.

For Institutional Investment Use Only

DOFU 6-2019