I entered the pension/investment industry in October 1981. In fact, it was October 13, 1981, and the US 10-year Treasury was trading at a yield of 14.7% at that time. US interest rates have fallen steadily since then to the nearly historic levels at which they trade today. As the chart below reflects, rates trended higher for the 30-years prior to the 1981 peak and it has been mostly downhill since then. What a ride!
That said, you’d have to be in your early 60’s and at least a 40-year veteran to have experienced a bear market in bonds within the US. Sure, there have been brief periods when one’s mettle may have been tested, but the anguish and confusion brought on by a sustained bear market correction has been avoided by all but a few of us long-timers. It will be interesting to see how most market participants react.
For sponsors of pension plans, especially those in the public and multiemployer arenas, it will be challenging to see how they reconfigure the asset allocation to account for the likelihood of total return-oriented bond portfolios generating negative returns as rates rise. Achieving that ROA may become even more challenging. I specifically didn’t mention corporate plan sponsors because of two reasons: 1) they are exiting the pension game, and 2) they have their focus squarely on the plan’s liabilities to a far greater extent than those not swimming in the corporate pool – thanks to FASB. By adopting a greater focus on asset/liability management, corporate sponsors appreciate the fact that a cash flow matching bond portfolio’s interest-rate sensitivity is mitigated because assets and liabilities will move in lock-step with one another.
How much would rates have to back up to generate a negative total return? NOT MUCH! As the information below highlights, rates only have to back up by 25 bps, which could happen in a week, for bond programs as short as a 5-year duration strategy to have a negative annual return.
Price Return is determined by the duration of the bond
|Duration||YTM||+25 bps||+50 bps|
|5-Yr Treasury||4.8 years||1.19%||-1.20%||-2.40%|
|5-yr A Corporate||4.1 years||1.63%||-1.03%||-2.05%|
|10-Yr Treasury||9.2 years||1.40%||-2.30%||-4.60%|
|10-yr A Corporate||8.3 years||2.26%||-2.08%||-4.15%|
|30-Yr Treasury||22.8 years||1.81%||-5.70%||-11.40%|
|30-yr A Corporate||19.9 years||2.87%||-4.98%||-9.95%|
Historically, US real interest rates have provided at least 1%-2% premium versus inflation. In today’s 7% inflation environment, real rates are trading at a negative 5% real return (30-year is at 2.12%). For how long will bond investors tolerate this situation? Given the lack of experience in managing through a bond bear market, it will be interesting to see the strategies that are adopted. One proven approach is to manage assets versus liabilities through a cash flow matching (CDI) strategy. Because asset cash flows are matched against liability cash flows, which are future values, interest rate risk has been eliminated. There is no more important risk to manage in bond land than interest rate risk. We’d be happy to share our insights with you. We’ve all enjoyed this incredible bull market, but after 39 great years, I believe that the party is over. The hangover that we experience may need more than a couple of Advil to cure!