Nuclear decommissioning trusts (NDTs), the pools of money accumulated over decades used to dismantle nuclear power plants and safely dispose of radioactive materials, allocate about 40% of their assets to fixed income securities.Footnote1 This is problematic, however, when NDTs have average annual after-tax return targets of 5%Footnote2 and the yield-to- maturity of the Bloomberg Barclays US Aggregate Bond Index (BBAG) is just 1.6%. The solution, in our view, is to look beyond benchmark-oriented core bonds to a broader set of fixed income strategies.
In recent years, the pool of assets in U.S. NDTs has grown by two-thirds, from $45 billion in 2010 to nearly $75 billion.Footnote3 Despite the dramatic growth and steady contributions by NDT sponsors, funding shortfalls have persisted as decommissioning cost estimates continued to climb. With the U.S. power-generation mix shifting away from nuclear energy and more nuclear plants starting the decommissioning process, the need for NDTs to grow assets to close funded status shortfalls has never been greater.
The portfolios of NDTs are dominated by public equities and core fixed income. At 40% of the average NDT portfolio, core fixed income (proxied by the BBAG) is a meaningful component for most NDTs. Historically, the BBAG’s starting yield has been a strong predictor of the index’s subsequent five-year annualized returns, with a correlation greater than 90%. With the BBAG yield near historical lows, PIMCO estimates that the average NDT’s fixed income allocation might return only 1% annually over the next five years, while the after-tax return of the total portfolio may be closer to 3% – well short of most NDTs’ 5% targets (see Figure 1). Assuming a 1% return from fixed income, equities in the average NDT portfolio would likely need 10% annual returns to realize a total portfolio return of 5% after tax. Given current equity valuations, though, that seems like a high hurdle.
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NDT sponsors are left with few obvious choices. Increasing return potential by boosting equity allocations may bust the risk budget and feel uncomfortable. Yet making no change risks accepting intolerably low performance.
An alternative is to seek more from the fixed income allocation itself – for instance, by broadening the opportunity set of underlying strategies and emphasizing active management, which may add more value in fixed income than in equitiesFootnote4 (see our Research piece, “Bonds Are Different: Active Versus Passive Management in 12 Points”). If implemented appropriately, enhancing the fixed income allocation may improve both return potential and alignment with the NDT’s projected profile of decommissioning expenses.
Barbell-shaped liability profile
We bring a liability-aware framework to our NDT investment solutions practice, one which is cognizant of the projected timing and magnitude of anticipated decommissioning expenses. While each NDT is unique, it is typical for the decommissioning process to take well over a decade to complete, with relatively large expenses required both in the early years and in the final stages of decommissioning.
Therefore, the profile of an NDT’s projected decommissioning expenses often resembles a barbell shape.
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From an investment standpoint, a barbell-shaped liability profile that extends more than a decade into the future has multiple implications. First, it suggests that most NDTs (including those still in the accumulation phase and those in early decommissioning) still have a long time horizon before decommissioning is complete. This provides an opportunity to pursue more dynamic public and private fixed income strategies that target higher returns. At the same time, near- term liabilities may be more efficiently met with a customized liquidity-management strategy than a standard benchmark-oriented approach. As Figure 2 shows, an array of fixed income strategies can be tailored to an NDT’s liability and risk profiles, with underlying strategy allocations sized to match each NDT’s short-term and long-term needs.
NDT fixed income strategies
Here’s a look at how three fixed income strategies have the potential to help NDTs close funding shortfalls:
Multi-sector fixed income may enhance flexibility and yield
Relative to passive and benchmark-driven core bond strategies, an active multi-sector approach increases the breadth of the investable universe and the ability to pursue opportunities as they arise. Portfolio yield may be increased by selectively incorporating non-core market segments with attractive risk-adjusted return potential, such as high yield, municipals, and emerging markets (EM) bonds. For example, an equally weighted blend of investment grade, high yield, and EM debt currently yields 3.4%, more than double the yield of the BBAG.Footnote5 The additional flexibility in active multi-sector strategies may also enhance returns by capturing tactical opportunities following market dislocations, as we saw after the COVID-19 crisis in March 2020. While higher-yielding strategies may introduce a modest step-up in volatility relative to core bonds, in our view the incremental return potential outweighs the risk differential, particularly given NDTs’ target return objectives.
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Private credit increases long-term return potential
For NDTs with a sufficiently long investment horizon and guideline flexibility to incorporate greater risk and less liquid investments, private markets provide a distinct slate of opportunities, enabling investors to target a liquidity premium and higher returns. Among private market investments, our researchFootnote6 indicates that private credit has generated higher and more consistent alpha than private equity, and offers better diversification potential. As Figure 3 shows, there is limited risk factor overlap between broad private credit strategies and the traditional stock and bond exposures that dominate most NDT portfolios. Furthermore, broad private credit strategies may help NDT sponsors reduce risk relative to equities over time, while targeting greater and more consistent income.
Custom liquidity management can help address near-term liabilities
Meeting shorter-term decommissioning expenses efficiently is also critical. In today’s environment, holding significant excess cash to cover near-term liabilities creates a drag on returns.
Similarly, funding liquidity needs by repeatedly rebalancing out of benchmark-oriented bond or equity portfolios is undesirable due to transaction costs and taxes. To address near-term liabilities more efficiently, NDT sponsors can consider a customized cash flow driven investment (CDI) approach designed to match the timing and magnitude of projected decommissioning expenses. In addition to potentially yielding significantly more than cash, a well-constructed CDI portfolio may naturally generate cash flows to meet decommissioning payments.
For NDT sponsors that wish to maintain an allocation to short- term fixed income but are not certain enough about upcoming decommissioning payments to adopt a CDI approach, focusing on active management remains key, in our view. Particularly with money market rates near zero, alpha potential from active short-term strategies may be more meaningful because it will often represent a much larger portion of the investment’s overall return.Footnote7 (See our Featured Solution, “How Active Short-Term Strategies Can Fill the Void Left by the Diminished Money Market Landscape”.)
The way forward
Looking ahead, NDT sponsors are likely to face a challenge achieving target return objectives given current capital market valuations. However, we see multiple opportunities to improve return prospects by refining the fixed income strategy, which represents 40% of the average NDT portfolio. While many NDTs rely primarily on benchmark-oriented core bond strategies, a more nuanced approach may be better suited to NDT objectives. In particular, higher-yielding multi-sector strategies and private credit may boost long-term returns to meet long duration liabilities, with shorter-term expenses covered by more efficient liquidity management strategies such as CDI. Together, these strategic opportunities may increase NDTs’ estimated returns and provide greater scope for alpha potential. As NDTs prepare for and start executing their decommissioning plans, active management could be increasingly important.
1 “2018 NDT Survey” NISA Investment Advisors, LLC. 31 December 2018.Return to content↩
2 “2018 NDT Survey” NISA Investment Advisors, LLC. 31 December 2018.Return to content↩
3 “2018 NDT Survey” NISA Investment Advisors, LLC. 31 December 2018.Return to content↩
4 Baz, Jamil, Helen Guo, Ravi Mattu, James Moore. 2017. “Bonds Are Different: Active Versus Passive Management in 12 Points.”Return to content↩
5 Equally weighted blend of the following three indices: Bloomberg Barclays Global Aggregate Credit ex EM Index (USD hedged), BofA Merrill Lynch High Yield BB-B Rated Constrained Developed Market Only Index (USD hedged), and JPMorgan EMBI Global.Return to content↩
6 See PIMCO research presentation, “Private Asset Returns and Allocation.” Available upon request.Return to content↩
7 Schneider, Jerome, Kenneth Chambers. 2020. “How Active Short-Term Strategies Can Fill the Void Left by the Diminished Money Market Landscape.”Return to content↩
SUMMARY
- Nuclear Decommissioning Trusts (NDTs) may face a challenge achieving target return objectives given their emphasis on benchmark-oriented core bonds amid the prevailing low-yield environment.
- However, there are multiple ways for NDT sponsors to seek more from fixed income allocations, which may improve both return potential and alignment with the NDT’s projected liability profile.
- An enhanced fixed income portfolio may include higher-yielding multi-sector strategies and private credit to boost long-term returns to meet long duration liabilities, with shorter-term expenses covered by more efficient liquidity management strategies such as cashflow driven investment.
THE AUTHOR
Portfolio Manager, Liability Driven Investment and Credit
DISCLOSURES
Past performance is not a guarantee or a reliable indicator of future results.
A word about risk: All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax. Private credit involves an investment in non-publically traded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy. Diversification does not ensure against loss.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.
ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.
The continued long term impact of COVID-19 on credit markets and global economic activity remains uncertain as events such as development of treatments, government actions, and other economic factors evolve. The views expressed are as of the date recorded, and may not reflect recent market developments.
There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.
Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The MSCI All Country World ex US Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Index consists of 46 country indices comprising 22 developed and 24 emerging market country indices. Russell 2000® Index is composed of 2,000 of the smallest companies in the Russell 3000 Index and is considered to be representative of the small cap market in general. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The Index focuses on the large-cap segment of the U.S. equities market.
It is not possible to invest directly in an unmanaged index.
PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2021, PIMCO.
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