- Some plan sponsors are holding off implementing liability-driven investing (LDI), anticipating that the Federal Reserve will soon commence a rate hike cycle.
- However, the intuition that rising short-term rates will result in greater valuation declines for long-duration credit compared to intermediate bonds may not be correct.
- A consideration of the future trajectory of interest rates and the future shape of the yield curve suggests positive total return potential for long-duration credit over the next couple of years.
- Arguably, the possibility of a shift in the balance of supply and demand also makes a compelling case against delaying LDI. A rise in short-term rates may trigger an unprecedented surge in implementation, just when issuance of long-duration bonds is likely to wane.
- Adopting (or proceeding with) a planned LDI strategy could help sponsors avoid possible future market conditions in which implementation may be notably more challenging.
Amid Low Bond Yields, Some Plan Sponsors Consider Delaying LDI Implementation Treasury Yields
Focus on the Federal Funds Target, Miss the Bigger Picture?
The Fed is widely expected to begin raising the federal funds rate by the end of 2015. Cognizant that a period in which the official interest rate is progressively raised may soon begin, many plan sponsors have decided to delay implementation of LDI. With bond yields set to rise, the argument goes, why not wait until the Fed has embarked on rate hikes and bonds are less expensive?
The question is a perfectly sensible one, but it does rest on an assumption that bears further investigation. In particular, plan sponsors that are adopting a wait-and-see approach to LDI may be under the impression that a higher fed funds target rate necessarily results in equally higher longer term yields.
History, however, shows that this is not always the case, and that the relationship between short- and long-term rates varies. The shape of the yield curve can change quite dramatically, alternating between extended periods of flattening (when the gap between shorter and longer term yields narrows) and steepening (when the gap widens), punctuated with sharp short-term moves.
With that in mind, we believe that plan sponsors who have questions about the timing of implementing LDI should look beyond the absolute level of the fed funds rate. For instance, it’s possible that in the future, LDI implementation may be more costly and difficult if, as expected, long-duration credit grows scarce (more on that later). And, even if short-term rates rise, a long-duration strategy could still fare relatively well in that kind of scenario — depending on how the yield curve’s shape changes.
To arrive at a better-informed assessment of the relative attractiveness of a long duration strategy, we suggest that plan sponsors consider interest rate forward curves. In essence, these curves show the market’s expectation for how the yield curve will look at specified points in the future. Used in combination with appropriate bond market indexes (serving as proxies for a broadly diversified bond portfolio and a portfolio focused on long-duration bonds), forward curves can help plan sponsors estimate possible changes in the value of different portfolios.
Consider a hypothetical example where a sponsor is considering whether to maintain its current intermediate bond portfolio and delay reallocating into a long-duration portfolio until two years in the future, when it expects the Fed to be well into its rate hike cycle. To help decide between reallocating to long duration now or waiting two years, the sponsor could calculate expected total returns over the next two years — using the Bloomberg Barclays U.S. Aggregate Index and Bloomberg Barclays Long Government/Credit Index as proxies for the current portfolio, and a long-duration portfolio.
Interest Rate Forward Curves Show Market Expectations for Future Rates Forward Interest Rates (as of June 30, 2015)
The projected impact of expected interest rate movements on each portfolio over the next two years can then be estimated in a few simple steps:
- Note the current yield on each index. As of June 30, 2015, the yields on the Bloomberg Barclays U.S. Aggregate Index and Bloomberg Barclays Long Government/Credit Index were 2.39% and 4.20%, respectively.
- For each index, identify the appropriate interest rate to use for calculation of accumulated yield and total return. An interpolated six-year Treasury note has a comparable duration (about five years) to the Bloomberg Barclays U.S. Aggregate Index; a 20-year Treasury bond (duration of about 15 years) is an appropriate choice for the Bloomberg Barclays Long Government/Credit Index.
- Calculate the projected cumulative impact of expected interest rate moves indicated by forward curves. Use simple bond math to iteratively calculate accumulated yield, capital loss and expected total return using the appropriate points on the forward curves (six years and 20 years, in this example) to represent future interest rate moves.
In this way, sponsors can use forward rates and market indexes to gain an informed perspective on how the value of a long-duration portfolio may change compared to another diversified bond portfolio. Of course, this is in no way a prediction. Forward curves can only ever offer an indication of current expectations about future rates.
Still, this type of analysis can be an eye-opener and may lead to some surprising conclusions. As our hypothetical example illustrates, it’s quite possible for a portfolio whose duration is matched to the Bloomberg Barclays Long Duration Government/Credit Index to outperform a portfolio benchmarked to the Bloomberg Barclays U.S. Aggregate Index in a rising rate/flattening yield curve environment.
The LDI Waiting Game May Be a Difficult One to Win
For many corporate plan sponsors, experiences in 2014 emphasized once again that — even in an environment of strong asset returns — a plan’s funded status can quickly deteriorate in the absence of LDI.
For instance, recent research from actuarial and consulting firm Milliman found that for the U.S. public companies with the 100 largest defined benefit plan assets, the overall funded ratio declined from 87.7% at year-end 2013 to 81.7% at the end of 2014. Though this decline equated to $131.1 billion overall, a number of sponsors and their plans fared relatively well, leading the authors of the Milliman 2015 Pension Funding Study to conclude: “Those plan sponsors that heavily de-risked and invested in LDI strategies at the beginning of 2014 ended up having a banner year.”
Potential Returns for a Long Duration Portfolio Appear Relatively Attractive
If interest rates do indeed move higher in 2015, three key criteria used in LDI glide path allocation — interest rates, funded status and relative value of equities/other asset classes — could to varying degrees make the case for increased allocation to long-duration bonds.
Currently, the new-issue market for long credit is healthy, and adequate supply continues to be met with strong demand. Pricing appears rational and the secondary-market liquidity — though lower than it once was — enables sponsors to construct an appropriate long-duration portfolio within a reasonable period.
Unfortunately, there’s good reason to believe that it may become increasingly difficult to implement LDI over the next few years. Specifically, our research suggests that plan sponsors seeking to initiate or expand a long-duration strategy may be confronted by a market supply-demand mismatch that makes it challenging to construct a diversified portfolio. Higher rates could slow down bond supply — especially for credit with longer maturities. If the pace of supply were to slacken as sponsors seek to increase their plans’ allocations to long duration corporates, it could result in significant difficulties for sponsors. Some plans may be unable to execute their bond purchases fully (or efficiently) amid prevailing price distortions and higher implementation costs.
Faced with this potentially challenging outlook, we think it’s crucial for corporate sponsors to revisit the question of whether delaying LDI implementation makes sense. Dependent on the particular circumstances of a corporate sponsor and their plan, there are a variety of potentially attractive approaches to LDI that an active credit manager could develop using both cash bonds and derivatives.
Issuance May Slow After a Rate Rise, Possibly Triggering Supply-Demand Imbalance Long-Duration Credit With Maturities ≥ 13 Years U.S. Investment-Grade Supply ($ Billions)
- The price of long-duration credit doesn’t necessarily decline substantially following a rise in short-term rates.
- When weighing the merits of delaying LDI implementation, use forward curves to compare the return potential of different bond portfolios in light of expected changes in interest rates.
- Widespread acceptance of LDI and increased longevity suggests that — in the near future — supply may not fully meet growing demand for long-duration bonds.
- Issuance of corporate bonds with longer maturities could diminish as rates rise — resulting in reduced supply at a time of increased demand. Arguably, LDI implementation may become more challenging in the not-too-distant future.
Three Reasons Why Demand for Long-Duration Credit May Rise
- Hundreds of billions of dollars of pent-up demand. Milliman estimated that the 100 largest corporate defined benefit (DB) plans had $1.76 trillion of liabilities and an overall funded status of 84.1% as of May 31. Higher interest rates in the next year or so could push this up to around 95% and trigger a wave of LDI activity. Annual demand for long-duration credit could, according to some estimates, rise by $150 billion (or multiples of that) over the next few years.
- Greater life expectancy. Many firms face a significant jump in their plan liabilities since revised mortality assumptions were published by the Society of Actuaries in October 2014. Moody’s Investors Service estimated aggregate liabilities will increase by $110 billion.
- Public pensions (maybe). Accounting rules for public pension plans are moving in a direction that suggests that, in the not-too-distant future, states, municipalities and other entities may also seek to increase their allocations to long-dated credit.