October 2016

Corporate Pension Plans Should More Actively Consider Credit Spreads When Managing Pension Liability and Balance Sheet Risk, Especially in This Low-Rate Environment

While corporate plan sponsors are keenly aware of interest rate risk within their defined benefit plans, few fully appreciate the complex and significant risk posed by the shifting gap between Treasury and corporate bond yields

Boston, MA (October 6, 2016) – Corporate credit markets can substantially influence pension liabilities, a fact that pension plan sponsors often overlook. Many focus on how interest rates affect liabilities, and opt for an “off-the-shelf” approach to credit spread risk. Finding the right strategy to address this issue should be an ongoing and dynamic process. This is particularly critical since the appropriate balance of investments will change in different economic environments. Disregarding the problem can have long-term repercussions for corporate balance sheets, according to a new research report from global investment firm Cambridge Associates.

Don’t Forget the Credit Spread!” encourages chief financial officers, treasurers and investment committees of corporate pension plans to examine their plans’ embedded credit spread risk – in other words, how and why changes in corporate bond yields can have material effects on plan liabilities.

“It’s important that plan sponsors understand the potential impact of corporate credit markets on both sides of the corporate balance sheet, and continually align their pension strategies appropriately in response,” says Brian McDonnell, Global Head of the Pension Practice at Cambridge Associates. “Neglecting this critical element otherwise can be a costly mistake.”

Under U.S. accounting standards, corporate plan sponsors determine the current value of their pension obligations using a discount rate based on yields on high-quality corporate bonds – specifically, Aa-rated bonds. Yields on these bonds are composed of Treasury bond yields and corporate “credit spreads” – in this case, the difference in yield between Treasury bonds and corporate bonds.

In managing pension assets, particularly the liability hedging portfolios designed to mitigate changes in the discount rate, plan sponsors are keenly aware of how interest rate changes can affect the Treasury yield component of their discount rate. Yet in this very important focus on interest rates, they often fail to fully take into account corporate credit spread risk.

Cambridge Associates research shows that even a small change in credit spreads can have a material impact on liabilities.

For typical plan liability durations of eight to 16 years, a change in credit spreads of 50 basis points (0.5%) translates to a change in value of roughly 4% to 8%. For a $500 million plan, this could increase pension expense by up to $10 million, and could change the corporate balance sheet by tens of millions of dollars. The last decade has seen significant volatility in credit spreads, with swings greater than 50 bps in 28% of all 12-month periods, making the matter even more important for plan sponsors today, notes the report.

Low interest rates have also compounded the liability risks associated with corporate credit markets. “Because rates are so low, the credit spread component could potentially account for up to 50% of the discount rate – which sponsors use to value pension liabilities – much more than five or seven years ago when it generally accounted for less than a quarter of the discount rate,” says Alex Pekker, Senior Investment Director in the Pension Practice at Cambridge Associates and author of the report.

There is no perfect hedge against risk in the corporate credit markets, according to the report, and reducing risks associated with corporate credit is far more complex than controlling interest rate risk. Still, plan sponsors often follow an overly simplistic path. In some cases, this may involve an extreme approach of using either 100% Treasuries or 100% corporate credits. Many pension investment consultants also simply place their liability-hedging portfolio in a market-based benchmark that includes both Treasury bonds and corporate bonds.

“This simplistic approach often leads to a mismatch between the liability-hedging portfolio and the liability discount rate,” says Pekker. “For example, when credit spreads widen, as they did last year, liability-hedging portfolios that are heavily invested in corporate bonds typically underperform the plan’s liabilities, leading to increases in the pension deficit.”

Mitigating risks associated with corporate credit is far more complex than controlling interest rate risk. Not only are Aa corporate bond spreads fairly volatile, but the universe itself is limited to a small number of issuers and durations, making adoption of a 100% Aa-rated portfolio both impractical and risky. In addition, corporate bonds’ performance in recent years has been highly correlated to assets such as alternatives and global and US equities, which typically comprise a significant portion of pensions’ growth portfolios. This correlation can cause unintended and adverse consequences in certain market cycles. As a result, when constructing the liability hedging portfolio, plan sponsors should think not only about the liabilities but the interaction with the growth portfolio as well.

The right balance between broader credits and Treasuries changes over time, and managing credit spread risk involves a nuanced and vigilant strategy. “Those in charge of a corporation’s pension plan investments should be asking if their liability-hedging portfolio sufficiently protects them from risks in today’s and tomorrow’s corporate credit markets. While addressing these questions can be complex, doing so is well worth the effort and can make a critical difference to pension plan health and a plan sponsor’s bottom line,” says Pekker.

For more information, or to speak with Alex Pekker or Brian McDonnell, please contact Eric Mosher, Sommerfield Communications, Inc., at (212) 255-8386 /

About Cambridge Associates

Cambridge Associates is a global investment firm founded in 1973 that builds customized investment portfolios for institutional investors and private clients around the world. Working alongside its early clients, among them several leading universities, the firm pioneered the strategy of high equity orientation and broad diversification, which since the 1980s has been a primary driver of performance for these leading fiduciary investors. Cambridge Associates serves over 1,000 global investors – primarily foundations and endowments, pensions and family offices – and delivers a range of services, including outsourced investment (OCIO) solutions, traditional consulting services, and access to research and tools across global asset classes. Cambridge Associates has more than 1,200 employees – including over 150 research staff – serving its client base globally.  The firm maintains offices in Arlington, VA; Boston; Dallas; Menlo Park and San Francisco, CA; London; Singapore; Sydney; and Beijing. Cambridge Associates consists of five global investment consulting affiliates that are all under common ownership and control. For more information about Cambridge Associates, please visit

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