While challenging to funding ratios, recent market volatility presents an opportunity to refresh strategic and tactical risk budgets.
Despite historic low rates, we caution against wholesale reductions in interest rate hedge ratios.
Rather than attempting to time the bottom, we believe legging into credit fixed income via total return or buy and maintain is reasonable at today’s spread levels.
Take time to reestablish governance around re-risking decision-making and glide path execution.
Recognize that liability headwinds are coming and consider expanding outside of traditional long corporate bonds to overcome them.
Plan sponsors are well aware of the staggering drop in Treasury yields since the beginning of the year coupled with an equity bear market and the corresponding impact on pension plan funding status. As of March 19, 2020, the S&P 500® Index was down approximately 25% year to date and the 30-year Treasury yield had decreased approximately 75 basis points.
The 30-year Treasury yield actually fell below 1.00% for the first time on record on March 9, but has since sold off modestly. Importantly, credit spreads have also widened significantly (100 to 197 basis points for long corporates depending on the quality) and have more than offset the decrease in Treasury yields that make up the discount rate mix. As of March 19, we estimate the average plan’s discount rate rose by approximately 64 basis points since the beginning of the year, which provides some solace to plans' funded status calculations.
Putting this all together, plans that had less equity exposure and more Treasury exposure over this period were generally more resilient than plans with large equity allocations or those which were underhedged versus rates. We estimate that a hypothetical plan with a simple allocation of 70% Russell 3000® Index, 15% Bloomberg Barclays Long Corporate and 15% Bloomberg Barclays Long Government would have seen a funded status drop of more than 17% on a year-to-date basis. A more conservative hypothetical allocation of 30% Russell 3000 Index, 40% Bloomberg Barclays Long Corporate and 30% Bloomberg Barclays Long Government would have seen a drop of approximately 5% in funded status since the end of 2019.
At the most basic level, now could be a good time to reset and validate a plan’s funding ratio risk budget. The recent market volatility has likely impacted not only the market value and liability value of the plan but also the liability duration, the mix of return-seeking assets (RSA) versus liability-hedging assets (LHA) and, the mix of credit versus Treasurys within the LHA allocation. It is important to level-set to today’s market data and then use the appropriate diagnostic tools to break down the funding ratio risk budget into components. For many plans, interest rate risk may still be a large portion of overall risk, which does not necessarily mean a reduction in hedge ratios is warranted. But until plan sponsors have a clear and current picture, it will be difficult to make informed decisions.
For many plans, Treasury exposure is now likely to be overweight versus credit within the LHA allocation. Harnessing gains from Treasury positions may be a reasonable step as long as it is done with caution and an eye toward overall plan interest rate risk. This is especially important in the near term as the Treasury market has experienced unprecedented liquidity issues. The amount of overall interest rate risk to hedge is a fundamental question that all plans face on a continuous basis. Answers will depend on several factors, including a plan’s funded status, plan status (open, closed or frozen), plan sponsor risk tolerance, and pension plan size relative to the organization as a whole. We would generally suggest setting overall interest rate hedge ratio targets at a strategic level, while keeping tactical interest rate allocations to a minimum.
While enticing at today’s rate levels, we would caution against significant tactical reductions in interest rate hedge ratios even after recent rate changes. Based on several years of negative rates across Europe and Japan, we know the lower bound on rates in the US is not necessarily zero. While we would surmise there is a higher ceiling on the future level of rates as compared to a floor, we believe it is still rational to maintain a substantial allocation to long-duration government bonds to hedge against a pension liability that is measured using long-duration interest rates.
This may be especially true for plans that are at or above 100% funded and/or are hard frozen to new participants. There is little upside to taking on interest rate risk for plans in this situation, despite historical low yields. Even if rates reach zero or negative, we’ve seen from other developed country yield curves that rates can fall through intuitive lower bounds and go even more negative.
While the path of future interest rates is anyone’s guess, credit spreads are also at an inflection point in terms of their future direction. We believe it is reasonable to consider modest rebalancing of Treasury gains back into credit at today’s more attractive entry points. While reallocating into long-duration corporate bonds can be a good place to start, we believe this is an opportunity to expand the menu of asset classes to use within the LHA bucket. Our research shows that incorporating a strategy that allocates to a wide range of fixed income asset classes can help reduce overall plan funded ratio volatility while helping to provide additional opportunities to generate excess return potential. Pairing a multisector credit approach with a Treasury futures overlay to match the liability duration exposures is a relatively simple way to diversify away from long corporate exposure, which has tended to be highly concentrated in a few issuers. An opportunistic strategy that can access high yield (including fallen angels, which we expect to be more prevalent), bank loans, emerging market debt and securitized asset classes can be additive. This is especially true through the lens of wider spread levels at today’s entry point across these asset classes. Of course, there is a material risk that spreads go wider and defaults and downgrades accelerate. Therefore we would suggest starting small and increasing the allocation as markets begin to stabilize.
If rebalancing back into total return credit strategies does not seem favorable given potential future spread volatility, plan sponsors could consider allocating to a near-term cash-flow-generating strategy where the intention is to hold until maturity. We believe this can be an appropriate strategy in most market environments, but given recent turmoil, we believe it could be especially appealing today. First, credit spreads are significantly wider than in early-to-mid-February, which makes buy and maintain strategies look more attractive. A buy and maintain portfolio may expect to earn something close to the starting yield less the impact of any defaults. Another way to say this is that spread volatility risk is significantly lower than that of a total return mandate. By restricting this type of mandate to high-quality corporate bonds, plan sponsors may increase the likelihood of earning the starting yield, which, as mentioned earlier, is more favorable today. Second, sponsors could use the maturing cash flows of this mandate to help meet ongoing benefit payments which would save the plan from having to sell equities each month—particularly painful after they’ve sold off 25%. A buy and maintain strategy can provide more certainty as compared to rebalancing into extremely volatile equity markets, both in future expected returns and future cash flows.
With declines in funding levels due to the recent selloffs, it is likely that plan sponsors face a decision of whether or not to re-risk. It is often said that timing the bottom of markets is like catching a falling knife and we don’t advise attempting to catch that knife now. What we will say is that now is perhaps the time to reaffirm the governance around how asset allocation and glide path decisions get made. Analyzing who has the decision-making authority and how quickly portfolio changes can be implemented is critical. We would not suggest automatic re-risking when funded status falls but instead an assessment of what drove the funded status decrease, how forward-looking return expectations have changed across asset classes and what the appetite is for funding volatility going forward. Selling out of long-duration fixed income today to add to equities may cause undue transaction costs and effectively unwinds prior de-risking decisions. Overall, it’s about having the mechanisms in place to make informed decisions and implement them efficiently. From an investment standpoint, we believe an overlay structure can allow efficient rebalancing as markets change, both via Treasury futures and/or equity futures. Plans that have not delegated authority or those that do not have overlay plumbing in place will not necessarily be able to capture market dislocations effectively.
Perhaps one underappreciated aspect to the recent market turmoil is the potential impact of what we refer to as “liability headwinds.” By this, we mean that liability discount curves do not suffer from downgrades or defaults. Nearly all pension plans use liability discount curves that are based on a process that determines a group of high-quality corporate bonds and constructs a yield curve using those bonds‘ yields and maturities. If, for example, the curve uses a universe of 50 AA-rated corporate bonds and one bond in that universe gets downgraded from AA to single A, it would simply fall out of the universe and the curve construction process would move forward with the remaining 49 bonds. Compare this to a portfolio holding the downgraded bond where there is likely to be underperformance. All else being equal, the liability will tend to have higher performance than a similar market-based benchmark.
We raise this issue because liability headwinds tend to be exacerbated during times of market stress. The graph below shows the impact of this phenomenon since 2000, which equates to more than a 20% drop in funded status over time and more than a 1% impact on an annualized basis. Perhaps what is most interesting is how lumpy the impact can be. Much of the worst headwind stress came during 2001 and 2008 as well as when banks were downgraded in 2011. We’ve experienced very little stress since the global financial crisis. How much headwind we’ll experience based on what’s happening now remains to be seen, but we expect it to manifest in the coming months and years as even high-quality corporations can experience balance sheet and cash flow stress.
In terms of what can be done about this, we would highlight two key items. First, we believe active management is critical within LHA allocations across all market environments, but it is especially critical during times of market stress. In addition to seeking to avoid downgrades and defaults as much as possible, an active manager can be a crucial source of excess returns in order to potentially outperform a liability that is immune to default and downgrade risk. Second, we would again guide pension plans to asset classes outside of traditional long corporate bonds in order to increase expected returns relative to the liability. While this can be done via equities, private investments and other return-seeking assets, we also suggest expanding the asset classes within the LHA bucket to high yield, bank loans, emerging market debt and securitized assets. Recent credit spread widening has made these asset classes more attractive and when packaged with a simple Treasury futures overlay to extend duration, this can be a diversifying complement to traditional long-duration investment grade corporates.
The Loomis Sayles LDI Solutions group partners with clients and consultants to bring high-quality pension solutions to plan sponsors. Our distinct mix of actuarial and quantitative expertise helps supplement the well-established alpha engines that Loomis Sayles has delivered for decades. We provide in-depth market insights, customized investment solutions and robust proprietary asset-liability modeling capabilities to help plan sponsors meet their objectives.
1The information within pertains to corporate pension plans only.