Is it time to sell your long bonds?
America has been in a prolonged bull market for bonds since 1982 when long Treasuries hit 14% yields. Today that 30-year bond has a yield of just 2.0%. One needn’t think too long or hard to see why we have a funding crisis within defined benefit plans of all types. For those plans that have had exposure to the long end of the interest rate curve – congratulations – but is the party about to end? As we asked above, is it time to sell your long bonds?
With the 30-year U.S. Treasury Bond yield at 2.0%, an insignificant 13 basis point increase in yield to maturity would create a negative total return even over a year’s horizon. The silver lining here is that pension liabilities behave like bonds. If you have a pension deficit, as most plans do, leaving the deficit on the tail (longer benefit payment dates) seems like a prudent strategy at this time. If interest rates (discount rates) go up over time, these long liabilities will go down in present value, perhaps significantly, thereby enhancing the funded status without having to rely on the asset side of the equation to outperform.
Another proven strategy is to Cash Flow Match benefits chronologically for the next 10-years on a rolling basis (continue to add a year, as the previous year rolls off). This strategy eliminates interest rate risk, as we will be defeasing future values (benefit payments) and it will simultaneously buy time for the remaining assets (alpha assets) to grow without being touched to make benefit payments, especially given how many plans have dramatically increased their use of less liquid alternative investments.
With this approach you will want to replace all long bonds in your fund with a cash flow driven investing approach (CDI) for the next 10-years. Cash flow matching (using our Liability Beta Portfolio™) will secure the next 10-years benefits at low cost and low risk, help to stabilize the funded status of your plan, while also reducing the volatility of contribution expenses for that portion of the plan that has been defeased.
The Ryan ALM LBP is a cost optimization model that will fund benefits at low or optimal cost savings. This should be the core portfolio of any pension plan or LDI strategy. Since bonds shouldn’t be looked at as performance generators, you will also want to replace your generic market bond index benchmarks with a Custom Liability Index (CLI) that best represents the client’s benefit payment schedule. Replacing your bond index benchmark with our CLI will provide all the calculations and data needed to effectively manage assets vs. liabilities.
Lastly, if you believe in an inflation premium (2%+) on long bonds then we need 4% interest rates on long Treasuries. We don’t know when history will repeat itself, but it is time to prepare for an eventual interest rate correction on long maturities.