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Should pension plans take on BBB-rated investments?

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It might not be the safest route, but corporate defined benefit plans may do well investing in medium-rated corporate bonds, according to Standish Mellon Asset Management.

Defined benefit plans typically focus their corporate bond investments on A and higher-rated securities in an effort to insulate their plans from market volatility.

But certain “BBB”-rated paper, which is the lowest rating before a company’s debt falls to “junk bond” status, can lead to improved diversification and better returns, according to Standish Mellon, the Boston-based fixed-income specialist for BNY Mellon.

Of course, not all BBB paper is equally valuable.

“Active managers could seek to avoid BBB securities that are likely to be downgraded by public ratings agencies and add BBB securities of stable to improving credits to their portfolios,” said Andrew Catalan, managing director at Standish and author of the firm’s report on the topic.

“Such a strategy has the potential to help improve returns beyond those of a portfolio of only A-rated and higher indexed securities,” he added.

The paper says that sponsors may find a scarcity of the highest-rated bonds if plan sponsors as a whole decide to implement long-duration strategies to address the potential of rising interest rates.

The availability of A-rated and higher securities has declined significantly over the last 25 years, as the overall credit quality for U.S. firms has declined. By incorporating the right BBB paper, sponsors will give themselves more investable options, said the paper.

But is the risk too significant for plans and their participants? The paper suggests that BBB companies may be safer bets than most presume.

For one, they tend to be highly motivated to not drop in status, which would lower them to junk or speculative grade, and significantly raise their costs of issuing debt in the bond market.

“We believe these companies have an additional incentive beyond those of higher rated companies to maintain their ratings,” explained Catalan. 

“Falling from A to BBB may result in moderately higher financing costs. However, the consequences of dropping from BBB to speculative grade are much more significant,” he said.