Don’t Forget the Credit Spread!
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 credit spreads
- For US corporate pension plans, credit spreads are a substantial component of liability valuation and an increasingly material driver of pension funded status risk.
- Like interest rate risk, credit spread risk can be hedged with fixed income, but doing so is more challenging and less precise, due to the dynamic nature of the credit universe, the volatility of credit spreads, and the high quality of the liability discount rate.
- Effectively managing credit spread risk requires an active approach that takes into account the high correlation between credit spreads and growth assets and the relative size and “riskiness” of the growth portfolio.
- In a de-risking glide path, as the growth portfolio becomes relatively smaller and more conservative, credit exposure within the liability-hedging portfolio should increase and become more closely aligned with that of the liability.