At KCS, we have been sharing ideas with plan sponsors to reconfigure their existing fixed income exposure into an enhanced asset allocation framework that might just stabilize a plan’s funded status and contribution costs. The motivation has been driven by the fear of rising interest rates. Unfortunately, this fear has provided the impetus for many of our friends in the industry to shed exposure to domestic fixed income programs. Stop!
Despite the near unanimous expectation that rates have to rise from these “historically low levels”, the fact is that interest rates have actually fallen rather significantly year to date. In fact, the U.S. 10-year Treasury Bond has seen its yield fall by 37 bps (as of 4/15). The KCS crystal ball is no clearer than that of any other market participant, so why “guess” where rates are going.
We think it would be advantageous for plan sponsors to reconfigure their existing fixed income exposure to include a separate, lower risk portfolio that matches near term benefit payments for the next 5-7 years depending on the current funded ratio of the plan and projected future contributions. This strategy will improve the plan’s liquidity, while extending the investing horizon for less liquid assets that we would use to support their active portfolio.
We have recommended that the lower risk portfolio be invested in U.S. Treasury STRIPS to match benefit payments. However, that instrument’s name raises more questions than answers, and has often turned potential users off before the conversation really heats up. We are here today to say that STRIPS, although misunderstood, are actually low risk, useful fixed income securities.
STRIPS is an acronym for “separate trading of registered interest and principal securities”. Treasury STRIPS are fixed-income securities, sold at a significant discount to face value and offer no interest payments because they mature at par, which is why they are so good at matching projected cash flows. Backed by the U.S. government, STRIPS, which were first introduced in 1985, offer minimal risk and some tax benefits in certain states, replacing TIGRs and CATS (…retired to the zoo?!) as the dominant zero-coupon U.S. security.
If you are concerned about your plan’s funded status, the direction of interest rates and / or the current composition of your fixed income assets, call us to discuss a new path forward. We are here and ready to help you!