Balancing a Plan’s Risk Exposure with Securitized Fixed Income

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• On: 08/16/2024 09:48:26
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By: Dan Dreher, LGIM America 

“Crisis Risk Offset” or “Risk Mitigating” portfolios are designed to better protect assets during deep and extended equity market declines. Plans are increasingly recognizing the need for liquidity as fulfilling private market capital calls, quarterly rebalancing activity, and benefit payments are essential to their operations.

This is an excerpt from NCPERS Summer 2024 issue of PERSist.

Public pension plans have traditionally prioritized three key pillars in their investment strategies: diversification, enhanced return, and liquidity. However, achieving these objectives is increasingly challenging in today's financial landscape. Diversification has become more difficult as a smaller percentage of issuers now make up a larger portion of most standard public indices – i.e., top ten holdings make up 35% of S&P 500. Liquidity has also become a challenge amidst growing allocations to less liquid private market asset classes in exchange for higher expected returns – broad category has seen over $11 trillion in AUM growth in last 10 years.^1,2

Some plans have identified the need for a portfolio that helps balance these pillars. While oftentimes called “Risk Mitigating” or “Crisis Risk Offset” portfolios, they are designed to better protect assets during deep and extended equity market declines largely comprised of liquid investment strategies. Naming conventions aside, plans are recognizing the need for liquidity as fulfilling private market capital calls, quarterly rebalancing activity, and benefit payments are essential to their operations.

Securitized products: the sweet spot
These optimization efforts frequently include an allocation to securitized products – and in the face of modern financial challenges, securitized assets stand out as a compelling solution. Unlike some public indices, which are concentrated in a smaller percentage of issuers, securitized assets encompass a wide range of underlying asset classes and market sectors. They also offer a level of liquidity typically higher than private market assets, while still providing the potential for enhanced returns relative to other public fixed income investments.

However, at first glance, certain risk metrics can screen concerning – for example, the time series in Figure 1 of auto loan defaults prime and non-prime loans increasing to 2% and 12%, respectively. But a deeper look reveals a different story.



Securitized transactions are unique in that they are structured into multiple tranches, each with its own credit rating, rather than having a single rating for an individual bond. Tranches are arranged in a hierarchy based on seniority and risk. Senior tranches have higher credit ratings and are paid out first, while junior tranches, which are first to absorb losses, have lower ratings and higher yields. Additionally, “default rates” are not always as concerning as it sounds – many transactions are structured with built-in mechanisms for workouts and recoveries.

Customization and credit enhancements
Structuring within transactions is a key aspect of securitization that allows for the creation of securities with varying risk profiles to cater to different investor appetites. Credit enhancements are a primary customization tool and act as protection in the form of financial support against losses on securitized assets in adverse circumstances. From the investor's perspective, so long as the pool of assets does not experience losses above the enhancement level, the investor will receive full economic benefit. The level of credit enhancement, which aligns with the rating of each tranche, varies across asset class. Said differently, an investor with a credit enhancement at 40% would be insulated from the first 40% of losses in the transaction.

Figure 2 shows the same time series for auto loan defaults but this time we've overlaid recent credit enhancement levels for a given rating. We've also done the same with other securitized sectors (see Figure 3-4).







The default rates of securitized products can be misleading if not viewed in the context of tranche hierarchy. While lower tranches might experience higher defaults, this does not necessarily reflect the overall quality of the entire asset class. By concentrating on the higher-rated tranches, investors can benefit from strong credit enhancements and lower default risks, which can make the asset class more attractive than it might appear when considering risk metrics at the transaction level.

Securitized in public pension portfolios
Currently, many plans are using securitized products with a policy allocation between 15-20%. Others have recently signaled intentions to increase their allocation to a similar level.

Plans recognize the ability of securitized products to balance out the competing interests of diversification, enhanced return, and liquidity. The diversity of exposures – asset-type, sector, geography, liquidity, cash flow profile, discount margin, etc. – point to securitized products as a means of obtaining customized exposure without sacrificing any of the three pillars. And notably, the use of credit enhancement may offer an outlet for meaningful downside protection in adverse market conditions.

Endnotes:
¹ Bloomberg as of 6/25/2024
² Preqin from 12/31/2013 – 9/30/2023

Bio: Dan Dreher is a Solutions Strategist at LGIM America. In his role, he supports the design, structuring, management and business development of LGIM America investment strategies and is the primary liaison between prospects, clients, consultants and LGIM America investment disciplines.

Dan rejoined LGIM America in 2023 after co-creating Bopdrop Inc., a music sharing platform with over one million users. As Chief Operating Officer, he led all business development efforts while designing and implementing robust analytics tools dynamically synced with growth, revenue and cost models. Prior to this, Dan worked at LGIM America for over five years, most recently as a Senior Strategy Associate where he helped design solutions for LGIM America's client base as well as supported the development of new products and investment strategies.

Dan earned an AB in Politics from Princeton University. He holds a Series 3 license registered with the NFA. 

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