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Andres Rioja is the treasurer of Empresas Crianza. His duties have recently been expanded to include oversight of the firm's pension fund. Given his limited experience in overseeing investments, he is relying on an outside consultant. Rioja prepares a number of questions for his first meeting with the consultant, Manolo Priorat of Consulta Jerez.Priorat starts the meeting by summarizing the status of the defined-benefit pension plan to Rioja and makes the following statement: "The pension liability has duration of 14 and a present value of $4 billion. The liabilities are discounted using the spot rate on high-quality long-term corporate bonds. The existing asset portfolio covers 87.5% of these liabilities and is invested entirely in fixed-income assets. The plan assets have fallen short of the pension liabilities over the past five years because their durations are not properly matched. I am concerned that Crianza has selected the wrong benchmark for the pension plan. The current benchmark is a weighted average of the benchmarks for the various strategies employed in the investment of pension assets. I believe the appropriate benchmark should be the liability itself."Priorat and Rioja review the fixed-income funds in which the pension assets are currently invested. Portfolio managers have been given the mandate to meet or exceed their respective benchmarks based on their investment styles. Details of the various portfolios are provided in Exhibit 1. Rioja updates Priorat on Crianza's current plans for the pension plan. Rioja states, "Crianza will make a $500 million contribution to fully fund the plan and invest the funds in Treasury STRIPs. In addition, we would like to completely reallocate pension investments away from the fund that presents the greatest contingent claim risk and into the Long Corporate Bond Fund."Rioja then asks Priorat, "I would like to understand the risk profile of each index benchmark we have assigned to the portfolio managers. What measures are available to do this?" Priorat responds, "There are several key measures that come to mind. Effective duration measures the sensitivity of the index's price to a relatively small parallel shift in interest rates. For large nonparallel changes in interest rates, a convexity adjustment is used to improve the accuracy of the index's estimated price change. Key rate duration measures the effect of shifts in key points along the yield curve. Key rate durations are particularly useful for determining the relative attractiveness of various portfolio strategies, such as bullet strategies versus barbell strategies. Spread duration describes how a non-Treasury security's price will change as a result of the widening or narrowing of the spread contribution."Rioja then asks about the rationale for active managers to do secondary market trades. Priorat responds, "Secondary market trades should be evaluated in a total return framework. The exception is the yield or spread pickup trade, which should be evaluated in the context of additional yield. Credit-upside trades provide an opportunity for managers to capitalize on unexpected upgrades. Curve-adjustment trades are yet another example of investors expressing their interest rate views in the credit markets in anticipation of interest rate changes."Finally, Priorat offers further explanation of how active managers can add value. He notes, "Structural analysis of corporate bonds is an important part of active management. Credit bullets in conjunction with long-end Treasury structures are used in a barbell strategy. Callable bonds provide a spread premium that can be valuable to an investor during periods of rising interest rate volatility. Put structures will provide investors with some protection in the event interest rates rise sharply but not if the issuer has an unexpected credit event." |
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