Having had the chance to speak at and attend 18 conferences in the last 13 months, I can tell you that there was near universal acceptance of the expectation that interest rates in the US and abroad were going up. The thought was that all of the stimulus provided by QE would have to create economic growth and inflation. What happened?
As we witnessed during the first three months of 2014, interest rates for US Treasury bonds fell. In fact, the yield on the 10-year fell 31 bps in the quarter, and the 30-year T-bond rallied nearly 11%! Wow! Global growth is waning, many of the globe’s regions are experiencing extremely low levels of inflation, and high unemployment is lessening the demand for goods and services. All of these factors, and more, are tamping interest rates. Today’s bond market activity is only further exacerbating this move.
As we wrote in early January, we think that DB plans should not reduce their current fixed income exposure, but reconfigure it. Here is what we wrote earlier this year. We still think it makes sense.
From the KCS Blog on January 9, 2014:
What I’d like to highlight today is a new use for a plan’s current fixed income exposure. In day two of the conference, I attended a panel discussion titled, “Opportunities in Fixed Income and Credit Markets”. The panel was occupied by 4 senior investment pros (plan sponsor, consultant, and investment managers). They generally discussed the likelihood that interest rates were going to rise (I’m beginning to wonder if there is anyone out their who doesn’t think that rates will rise), and the implications of that movement on traditional fixed income portfolios. Most of the panelists talked about various sub-sectors (mortgages, asset backs, bank loans, etc) and which ones might hold up better. There was discussion about shortening duration, etc. They also talked about fixed income’s traditional role as an anchor to windward, a risk reducer, and a provider of liquidity.
However, only one individual mentioned taking a step back to truly contemplate the “role” of fixed income. He didn’t provide any further perspective, which is why I’m addressing the issue here and today. I believe (as do my partners at KCS) that a plan’s liabilities should be the focal point of any pension discussion. As such, they need to be the primary objective for the plan, the driver of asset allocation decisions and investment / portfolio structure. The asset class most similar in characteristic to liabilities is fixed income. As such, fixed income needs to play a prominent role in a defined benefit plan.
Instead of worrying about the implications from a rising interest rate environment on an LDI strategy that currently consists of long duration corporates, change the emphasis to matching near-term liabilities, by converting your current fixed income portfolio into a Treasury STRIP portfolio that matches cash flows with projected benefits (Beta portfolio). First, you are improving liquidity. Second, duration is shortened in an environment that may not be conducive to long bonds. Third, you are lengthening the investing time horizon for the balance of the corpus, which will allow asset classes / products with a liquidity premium a chance to capture that performance increment (Alpha portfolio). Finally, the funded status and contribution costs should begin to stabilize. As the Alpha portfolio outperforms liability growth (hopefully), siphon excess profits and extend the beta portfolio.
This is a proactive move to restructure the fixed income portfolio in an environment of uncertainty.
Lastly, I am not of the general school of thought that interest rates are definitely going to rise, and soon. I believe that we still have slack demand in our economy, brought on by underemployment, which will keep inflation in check and provide room for stable to slightly lower rates.