The fourth quarter of 2019 was the mirror image of the final months of 2018. The decade ended on a high note – or a low note, if you are focused on the level of credit spreads. At the end of 2018, fears of a slowing global economy drove credit spreads wider and interest rates lower. The U.S. Federal Reserve also raised interest rates at its final meeting of 2018, extending a tightening cycle it started three years earlier. Those trends began to reverse in 2019: The Fed adopted a more accommodative stance, the moderation in economic growth was not as drastic as feared and trade tensions eased toward the end of the year.

While the summer months are supposed to be a time to relax, the third quarter proved to be a stressful period for fixed income and pension managers. In August, the 10-year U.S. Treasury bond tested the lower bound of the 1.50%–3.00% range in which its yield has fluctuated since 2011 as concerns about global growth permeated the market. In addition, communications from the U.S. Federal Reserve’s July rate-setting meeting left investors wondering whether the central bank was committed to further easing. This drove spreads wider and rates lower, but the move in rates dominated and ultimately drove down pension plan discount rates even further.

Central banks continued to play a pivotal role in guiding investor sentiment during the second quarter. Signs of slowing growth, increased market volatility and trade tensions were enough to convince them that potential downside risks warranted a response. At its June meeting, the U.S. Federal Reserve clearly articulated the potential for policy rate cuts in the second half of 2019. The European Central Bank and the Bank of Japan conveyed similar messages. This shift improved investor sentiment and drove credit spreads lower; they finished the quarter slightly below where they began.

Since the early years of liability-driven investing (LDI), many defined benefit (DB) pension plan sponsors have cast a wide net for investments to reap higher returns and hedge long-term plan liabilities. While this has led some sponsors toward ever more creative and less traditional avenues to access long duration, the core hedging assets in most LDI programs remain investment-grade government and credit bonds, often weighted toward the long end (maturities of 10 years or more).

After a significant widening of spreads in the fourth quarter, credit markets rebounded along with equities and other risk assets during the first quarter. A key catalyst of positive sentiment was a more accommodative stance from the U.S. Federal Reserve. This drove U.S. Treasury yields lower across the yield curve and pushed the 10-year Treasury rate below the fed funds rate – a condition that has preceded each of the last three recessions by one to three years. Long-dated investment-grade credit spreads narrowed by 27 basis points (bps) to 173bps during the quarter. The spread tightening combined with lower Treasury yields cut the long corporate credit yield to 4.41% from 4.91%.

Global economic momentum decelerated in the fourth quarter. An inversion of two- and five-year yields and shifting growth expectations contributed to significant stock market volatility and wider credit spreads. Long duration investment-grade corporate bond spreads widened 47 basis points to 200bp, mostly due to falling U.S. Treasury yields.

To contribute, or not? It's a big question for plan sponsors. Our experience working with sponsors suggests that it's typically optimal for them to make some contributions — especially from an after-tax perspective. What’s more, there’s good reason to think that the economics of making contributions will become still more compelling over the next few years. Underfunded plans will face a large and growing cash penalty for deferring contributions. Because the economics are swinging strongly in favor of making contributions, plan sponsors with bond market access may even have an incentive to borrow to fund the plan.

For a long time, a rise in interest rates has been discussed and expected. While the Federal Reserve has finally begun its move away from its near-zero interest rate policy and a further rise in rates may now seem imminent, the past few years have for some sponsors underscored the fact that “being early” can prove expensive. Plan sponsors who want to prepare for higher rates should not pick strategies that are too sensitive to the precise timing of a rise in rates.

The Federal Reserve has finally begun its move away from its near-zero interest rate policy, and many plan sponsors may expect interest rates to rise further. From an LDI perspective, what should you do if and when rates rise, and discount rates increase accordingly? This, it turns out, is a simple question with a far-from-simple answer. Interest rates can go up for a variety of reasons. The economic backdrops in which liability discount rates may rise can be surprisingly different and, consequently, so can the behavior of asset prices.