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The role of private credit in the expanding LDI toolkit

  • Strategy insights

January 16, 2025 | 6 min read

Karen Simeone

Managing Director

Bill Cole, CFA, CAIA

Principal

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Higher interest rates and strong public equity returns have again pushed the funded status for the average corporate defined benefit plan above 100%.1 In response, some plans are transferring their pension liabilities to insurance companies via a pension risk transfer (PRT) to remove plan liabilities from their balance sheet and mitigate any volatility of future benefit payments. Others are retaining plan assets and liabilities on the sponsor’s balance sheet and exploring alternative strategies for managing their end-state portfolios to preserve their higher funded status while minimizing funded status volatility.

Though many plan sponsors have historically limited their liability hedging allocations to publicly traded investment grade credit and Treasuries, we believe there is a compelling opportunity to broaden the liability hedging toolkit to include private credit strategies. Below we examine how an allocation to senior private credit can help a liability hedging allocation work harder by increasing the portfolio’s yield and providing valuable sector diversification without meaningfully increasing funded status volatility when the portfolio’s duration is adjusted to account for the inclusion of a floating rate asset.

Why are allocators looking beyond the traditional liability hedging tools?

When managing an end-state portfolio, plan sponsors typically make meaningful allocations to liability hedging assets that reflect the interest rate and credit sensitivity of the liability. However, the returns of a well-designed liability hedging portfolio will often trail the growth of the liability by 50-100 bps per year.2 This is sometimes referred to as “downgrade drag,” an actuarial nuance that occurs due in large part to how downgraded securities are treated in the plan’s calculation of discount rate.

Plan sponsors often rely on cash contributions or higher returns from return-seeking assets to make up for downgrade drag. However, many plans, particularly those that are closed and frozen, are no longer receiving cash contributions or their return-seeking allocations are not large enough to close the gap. While oftentimes these closed or frozen plans allocate to shorter duration credit strategies to better match the shortening duration of plan liabilities, they need their liability hedging allocation to work harder to help the overall portfolio keep pace with the growth of the liability. As illustrated below, we believe that an allocation to a senior direct lending strategy can be a complement to these shorter duration investment grade credit strategies by providing a potential yield premium while also introducing important sector diversification.

Private credit: A liability hedging allocation that works harder

A direct lending strategy typically focuses on deals with cash flow profiles that are roughly in line with an intermediate credit allocation while offering an incremental credit spread of ~400-500 bps.3 Additionally, while much of the shorter duration investment grade credit market has outsized exposure to the banking and consumer sectors, the private credit market focuses more on business services, such as technology and healthcare, providing valuable sector diversification to what is a growing allocation in many liability hedging portfolios.

The graphic below shows how a plan sponsor could incorporate a direct lending allocation to a liability hedging portfolio to increase the portfolio’s yield and diversify their public credit exposure. In this example, the plan sponsor is managing a portfolio to hedge a pension liability with 11 years of interest rate duration. The first chart shows what a typical liability hedging allocation might look like with approximately 75% of the portfolio in publicly traded investment grade credit and 25% of the portfolio in Treasuries, with the duration of the Treasury allocation optimized to meet an 11-year duration. This traditional LDI portfolio yields 5.07%.4

Measuring the impact of private credit on an LDI portfolio

Traditional LDI portfolio
(11-year duration)

LDI portfolio with private credit
(11-year duration)

Source: HarbourVest and Bloomberg, data as of November 30, 2024, including index data from Bloomberg Long Credit Index, Bloomberg Intermediate Credit Index, Bloomberg Long Treasury Index, Bloomberg Intermediate Treasury Index. Direct lending proxy assumes 11.5% overall yield based on prevailing market yields, assuming 1:1 leverage. Past performance is not a reliable indicator of future results.

In the second chart above, we exchange the public intermediate credit allocation with an allocation to a senior direct lending strategy and re-optimize the remaining Treasury allocation to maintain an 11-year duration. The addition of a private credit allocation to the portfolio increases the yield of the portfolio to 6.08%, an increase of 101 basis points.5

Striking a balance between higher yields and funded status volatility

Increasing the liability hedging portfolio’s yield — and expected return — is an important step in preserving funded status for end-state portfolios. However, in doing so, plan sponsors must also consider how the introduction of a private credit allocation may impact funded status volatility and the portfolio’s liquidity profile.

Typically, the largest driver of funded status volatility is the duration mismatch between a liability hedging allocation and the liability. The floating rate nature of a direct lending strategy will typically shorten the duration of a liability hedging portfolio, which can be a distinct benefit for closed or frozen plans with shortening liabilities. However, other plan sponsors may need to recoup this duration in order to continue to match the duration of the plan’s liabilities. In the example above, we have illustrated how this is possible for plans with a standalone Treasury allocation. For other plans, this can be done synthetically with derivatives and the use of Treasury futures and/or interest rate swaps, and often through the use of a completion manager.

Plan sponsors must also consider the liquidity requirements of their plan. For many plans with liability durations between 10-12 years, it is relatively common for more than half of future plan benefit payments to not come due for at least 10 years. Near-term liquidity is less of an immediate concern for these plans, and they can afford to take on additional illiquidity that may come with an allocation to private credit in order to capture the potential yield premium being offered by today’s private credit market.

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Key takeaways

  • The average funded status for corporate defined benefit plans is above 100% and portfolios with meaningful allocations to liability hedging assets can likely benefit from expanding beyond traditional public fixed income to preserve funded status gains.
  • We believe there is a role for private credit in a liability hedging construct to generate incremental yield, preserve recent funded status gains, and diversify a liability hedging portfolio’s fixed income allocation.
  • To minimize the impact on funded status volatility, plan sponsors are advised to revisit the duration of their liability hedging portfolio to account for an allocation to a floating rate asset class such as private credit which can shorten the duration of the liability hedging portfolio.
Footnotes

  1. Milliman Pension Funding Index, as of November 2024.

  2. HarbourVest, data as of November 30, 2024.

  3. Yield differential reflects an average private credit yield of SOFR + 5% minus the yield to maturity of Bloomberg US Investment Grade Intermediate Credit Index.

  4. Source: HarbourVest and Bloomberg, data as of November 30, 2024, including index data from Bloomberg Long Credit Index, Bloomberg Intermediate Credit Index, Bloomberg Long Treasury Index, Bloomberg Intermediate Treasury Index. Past performance is not a reliable indicator of future results.

  5. Source: HarbourVest and Bloomberg, data as of November 30, 2024, including index data from Bloomberg Long Credit Index, Bloomberg Long Treasury Index, Bloomberg Intermediate Treasury Index. Direct lending proxy assumes 11.5% overall yield based on prevailing market yields, assuming 1:1 leverage as of November 30, 2024. Past performance is not a reliable indicator of future results.
Disclosure

HarbourVest Partners, LLC (“HarbourVest”) is a registered investment adviser under the Investment Advisers Act of 1940. This material is solely for informational purposes and should not be viewed as a current or past recommendation or an offer to sell or the solicitation to buy securities or adopt any investment strategy. The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication, are not definitive investment advice, and should not be relied upon as such. This material has been developed internally and/or obtained from sources believed to be reliable; however, HarbourVest does not guarantee the accuracy, adequacy or completeness of such information. There is no assurance that any events or projections will occur, and outcomes may be significantly different than the opinions shown here. This information, including any projections concerning financial market performance, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.

The information contained herein must be kept strictly confidential and may not be reproduced or redistributed in any format without the express written approval of HarbourVest.

Nothing herein should be construed as a solicitation, offer, recommendation, representation of suitability, legal advice, tax advice, or endorsement of any security or investment and should not be relied upon by you in evaluating the merits of investing in HarbourVest funds or in any other investment decision.

 

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(a) any recognised exchange company, recognised clearing house, recognised exchange controller or recognised investor compensation company, or any person authorised to provide automated trading services under section 95(2) of the SFO;

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(ii) is similarly constituted under the law of any place outside Hong Kong and, if it is regulated under the law of such place, is permitted to be operated under the law of such place,

or any person by whom any such scheme is operated;

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(j) any person of a class which is prescribed by rules made under section 397 of the SFO for the purposes of this paragraph as within the meaning of this definition for the purposes of the provisions of the SFO, or to the extent that it is prescribed by rules so made as within the meaning of this definition for the purposes of any provision of the SFO.

The first of such classes of additional “professional investor”, under the Securities and Futures (Professional Investor) Rules (Cap. 571D of the Laws of Hong Kong), are:

(k) any trust corporation (registered under Part VIII of the Trustee Ordinance (Cap. 29 of the Laws of Hong Kong) or the equivalent overseas) having been entrusted under the trust or trusts of which it acts as a trustee with total assets of not less than HK$40 million or its equivalent in any foreign currency at the relevant date (see below) or-

(i) as stated in the most recent audited financial statement prepared-

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(B) within 16 months before the relevant date;

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(B) within 16 months before the relevant date; or

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(A) in respect of the trust or any of the trusts; and

(B) within 12 months before the relevant date;

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(m) any corporation or partnership having-

(i) a portfolio of not less than HK$8 million or its equivalent in any foreign currency; or

(ii) total assets of not less than HK$40 million or its equivalent in any foreign currency, at the relevant date, or as ascertained by referring to-

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(B) within 16 months before the relevant date; or

(iv) one or more custodian statements issued to the corporation or partnership (as the case may be) within 12 months before the relevant date; and

(n) any corporation the sole business of which is to hold investments and which at the relevant date is wholly owned by any one or more of the following persons-

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For the purposes of paragraphs (k) to (n) above:

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(a) the Singapore Government;

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(f) a merchant bank that is licensed under the Banking Act 1970;

(g) a finance company that is licensed under the Finance Companies Act 1967;

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(i) a company licensed under the Trust Companies Act 2005;

(j) a holder of a capital markets services licence;

(k) an approved exchange;

(l) a recognised market operator;

(m) an approved clearing house;

(n) a recognised clearing house;

(o) a licensed trade repository;

(p) a licensed foreign trade repository;

(q) an approved holding company;

(r) a Depository as defined in section 81SF of the SFA;

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(w) a person who undertakes fund management activity (whether in Singapore or elsewhere) on behalf of not more than 30 qualified investors;

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An accredited investor as defined in Section 4A of the SFA and Securities and Futures (Classes of Investors) Regulations 2018 is:

(i)  an individual —

(A) whose net personal assets exceed in value $2 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;

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(BB) an investment product as defined in section 2(1) of the Financial Advisers Act 2001; or

(BC) any other asset as may be prescribed by regulations made under section 341; or

(C) whose income in the preceding 12 months is not less than $300,000 (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;

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(A) the most recent audited balance sheet of the corporation; or

(B) where the corporation is not required to prepare audited accounts regularly, a balance sheet of the corporation certified by the corporation as giving a true and fair view of the state of affairs of the corporation as of the date of the balance sheet, which date must be within the preceding 12 months;

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(vi) A partnership (other than a limited liability partnership) in which every partner is an accredited investor; or

(vii) A corporation which the entire share capital is owned by one or more persons, all of whom are accredited investors.

Continuation solutions encompass a host of transaction types in which a GP secures interim liquidity and/or additional primary capital for their LPs in a strongly performing asset, or set of assets, that the GP will continue to own and control. Specifically, they include continuation funds, new funds created by GPs for the purpose of acquiring the asset(s) that continue to be managed by the same GP and capitalized by one or several secondary buyers, or equity recapitalizations involving a direct equity or structured equity investment into a portfolio company. These transactions can also include a parallel investment from the GP’s latest fund into that same pool of assets (a “cross-fund trade”).