Bonds have enjoyed an incredible bull market run since 1982. Is the rally finally done? Unfortunately, my crystal ball is no better than anyone else’s so I don’t know when bonds will finally enter a bear market, but I can surmise that we are much closer to that happening than at any time in the last 30+ years, as inflation is beginning to present itself throughout our economy. In fact, the WSJ is reporting this morning that consumer prices surged 4.2% in April from one year ago to the highest level since 2008. In addition, we have the chart below from the BLS highlighting the fact that significant segments of our economy have seen huge spikes in cost since 2000, and given the significant stimulus, 2021 continues to fuel these trends.
Given where U.S. interest rates are today, traditional core fixed income programs are NOT sources of return (performance). Exposure to bonds will likely weigh on pension plan sponsors and their asset consultants in their pursuit of an asset allocation strategy that will help them achieve the desired return on assets (ROA), as yields hover far below the median ROA objective. What should pension plans do? They should use their bonds (fixed income exposure) as a source of cash flow, as bonds are the only assets with a known cash flow AND terminal value. Plan sponsors should take advantage of these positive attributes to build a cash flow matching strategy (CDI) to defease pension liabilities, improve liquidity, eliminate interest rate risk, and extend the investing horizon for the non-bond assets (alpha assets). Another benefit here is that if interest rates rise as a trend, a CDI strategy can reinvest at lower cost and earn more income while fixed income performance strategies suffer especially on long bonds.
A CDI approach will also allow for less fixed income exposure than a typical asset allocation strategy, while achieving the benefits highlighted above. With less dependence on traditional fixed income approaches, more of the plan’s assets can be invested in products/assets designed to generate greater returns. A CDI strategy also buys time since it defeases liabilities chronologically. By extending the investing horizon, these higher octane products can grow unencumbered as they are no longer a source of liquidity to meet benefit payments and plan expenses. History tells us that given time the S&P 500 performs better and better. Moreover, dividends reinvested represent over 50% of the S&P 500 growth since 1980. Thus, a CDI implementation creates a much more efficient asset allocation for the plan sponsor.
The Bloomberg Barclays Aggregate index declined -2.6% on a year-to-date basis through April 30th, even with a 0.8% “rally” in April. Long-bonds (>10-years) produced at least a -10% return for the four months. It could get really ugly, and fast! Rising rates will not negatively impact a CDI’s efficacy, as both assets and liabilities will move in lock-step. This is certainly more palatable than witnessing significant underperformance from a traditional fixed income strategy.