Last year in April, I recommended to Illinois Senators that they propose a Bill to allow Article 3 & 4 Police and Fire funds to invest in corporate debt obligations. The purpose is to significantly increase the interest income on pension fund fixed income investments. Corporate debt obligations typically offer from 1-3% higher annual interest returns than US Treasury and Agency securities.
Illinois pension funds desperately need higher annual investment income that is earned in a prudent way via “Investment Grade” quality rating limitations on corporate debt obligations. Illinois has an aggregate under funded public pension obligation that is near $80 Billion on net assets needed now to be fully funded to 100%. Increasing the annual interest income on the bond allocations in fund portfolios will greatly assist in closing the under funded pension gap.
Please see letter below that explains a proposition by my firm, Capital Management Associates, a Registered Investment Advisor to set in place appropriate guidelines for Illinois Public Pension Funds to utilize corporate debt obligation to 30% of pension fund assets:
April 2010
Dear Senator Lauzen and Senator Harmon,
There are a number of concerns, as noted below, that need to be addressed in the Article 3&4 pension Code Revision, the Bill, before it becomes a statute, in respect to allowing investments in corporate debt obligations via mutual funds, ETFs and portfolio accounts to a maximum of 30% of total pension fund assets. Each of these concerns has to do with avoiding excessive risk from allowing corporate debt obligations as an alternate investment in Government guaranteed debt obligations:
Maturity…How long the debt obligation is outstanding until maturity, to its par value redemption.
- Issuer Bond Weighting…The percent holding in any issuer to the total portfolio.
- Sector Weighing…The percent of total issuers in the same industry sector (Global Industry Classification Standards or GICS) to the total portfolio.
- Call Features…Having a debt obligation(s) called early before the full maturity is reached.
- Deferrable Features…Is the issuer able to legally defer making regular interest payments.
- Leverage…Does the mutual fund or ETF employ borrowing or debt leverage to increase its interest yield
- Rating drop below investment grade…If/when a purchased debt obligation is downgraded to below Investment Grade…What is security exit plan?
The following discussion covers the need to establish limitations on corporate bond investments to reduce financial risk to public fund assets.
Maturity
Limiting the maturity of a debt obligation allows the fund to set a maturity period in years on debt obligation investments to cover a time period compliant to the pension liability payout period…approx 30 years maximum. We recommend a 30 year maximum maturity term. This term coincides with the current 30 year maturity allowed under the Code for U.S. Government debt obligations.
Issuer Debt Obligation Weighting
Limiting the issuer debt obligation weighting to a maximum percent of portfolio assets helps to minimize company default risk on the fund portfolio. We recommend no greater than an industry-normal diversification standard of 3% maximum allocation to any one corporate issuer.
Sector Weighting
Setting a percent limit on the maximum investment allocation of corporate issuers to any one industry sector GICS (Industrials, Financials, Information Technology, etc) in the economy is a mechanism to limit risk exposure that may disproportionately impact certain economic sectors during extreme macro economic adversity. It would not be desirable allow a large percentage of corporate issuers in the bond portfolio to be invested in the financial industry sector that is systemically exposed to: higher interest rate risk, leverage and credit default risk, as an example. We recommend limiting Industry Sector allocations to a maximum15% in any one sector. This ensures that at least 7 sectors will be used creating broad economic diversification to the overall economy. The Global Industry Classification Standards or GICS should be used as this is a widely accepted benchmark. The 10 GICS sectors are Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Health Care, Financials, Information Technology, Telecommunication Services and Utilities.
Call Features
Callable debt obligations create a risk condition to the investor, whereby if a bond is called or redeemed well ahead of its stated maturity, that would exposes the fund to risk of having to reinvest assets at lower interest rates than what the original bond holding was issued at. We recommend allowing a maximum of up to 25% of the overall corporate debt obligation portfolio to be in callable bonds.
Deferrable Features
If a debt obligation is deferrable, it can legally suspend interest payments for many years. This would create an interest income cash flow shortage to a fund, jeopardizing its pension liability payouts. We recommend prohibiting deferrable corporate debt obligations.
Leverage
The use of debt leverage within bond mutual funds and ETFs to enhance overall interest yields is inherently dangerous. If interest rates were to soar, the effect is to financially collapse the mutual fund or ETFs viability. We recommend that no bond mutual fund, ETF or debt obligation portfolio account employ the use of debt leverage.
Rating drop below investment grade
The Standard and Poor’s (S&P) investment grade range for corporate bonds spans from AAA to BBB-. Pension funds could excessively weight BBB corporate debt obligations (for highest relative interest yields), but being in the lowest tier (BBB), these debt obligation have relatively high downside price risk if their rating falls to “below investment grade” (Junk). We recommend that if a corporate debt obligation holding is downgraded to below Investment Grade by two rating agencies, then the fund can hold the investment for up to 12 months from date of downgrade in anticipation of a corrective rating upgrade. If an Investment Grade rating is not reset for the debt obligation holding, the security must be sold.
Revision to ILL Code allowing corporate debt obligation investments.
Insert the following after Line 169 of the Revised Code
“Limitations on corporate debt security investments: (i) corporate debt maturity is limited to a maximum of 30 years from date of new issuance or remaining life of the security, (ii) no greater than 3% of the pension fund’s allowable 30% allocation to corporate debt assets can be invested in a single corporate issuer, (iii) no greater than 15% of the fund’s assets can be invested into any one GICS classified sector, (iv) deferrable interest debt obligations are prohibited, (v) a maximum of 25% in callable corporate debt obligations are permitted, (vi) no debt leverage is permitted within any bond mutual fund, ETF, or individual corporate debt portfolio, and (vii) if the investment grade rating by one or more of two standard credit rating services falls below investment grade, then the bond must be sold if it is still rated below investment grade by two credit rating services after a period of 12 months of the downgrade.
Sincerely,
Chuck Dushek