By: Russ Kamp, Managing Director, Ryan ALM, Inc.
A former colleague has for years provided me with an excellent monthly performance report from a terrific regional asset consulting firm. What had been a 7-8 page document of equity and fixed income indexes became a 5-page document in the middle of 2021. I was taken aback by the absence of the fixed income index section. I reached out to my former colleague and was told that “no one” was interested in fixed income so those indexes were removed by the consulting firm. Wow! I was shocked given the role that bonds play in all types of investment programs, especially corporate DB plans. I remember saying to myself that those that aren’t interested today might certainly be in a few months when interest rates start to rise.
Well, that period is upon us and the returns to a variety of fixed income benchmarks YTD are painful, and likely to get even more so if the US Federal Reserve can’t successfully navigate through this inflationary environment. After 39-years of a bond bull market, it is time to pay the piper. This benign neglect had me recall all of the “talk” in the late 1990s about a new paradigm. As you may recall, Value investing was dead and the only play in town was to invest in high momentum growth stocks. We all know what soon followed. Sound reminiscent of today’s environment?
Our markets move in cycles, such as Value versus Growth, large-capitalization stocks versus small caps, the US versus non-US, and on and on. Some of the cycles are longer than others, such as the US interest rate bull market cycle of nearly 40 years others are much shorter. These cycles are driven by market sentiment and cash flow. The building or unwinding of positions/strategies leads to strong or weak performance. This is how it has always been, and it will remain so. When it becomes so painful to maintain an exposure it is usually the time to double down not abandon ship.
Because of the nearly singular focus on return (ROA) as the primary objective in managing a DB pension plan, sponsors and their advisors have for years significantly expanded their use of equity and equity-like products. What this has done is increase both the cost of managing a plan and the volatility surrounding the potential outcomes. It has done very little to ensure success. If a pension system achieves the targeted ROA but fails to beat liability growth has the plan won? Of course not. But given that many sponsors (and their advisors) don’t know how their plan’s liabilities are behaving on a daily, monthly, or quarterly basis they are blind to whether or not their fund is meeting the primary pension objective of SECURING the promised benefits at a reasonable cost and with prudent risk.
I would suggest that now IS NOT THE TIME to close a blind eye as to how the fixed income market is performing. Traditional return-focused fixed income products are going to get hammered if the Fed isn’t successful in migrating through this inflationary environment. Use bonds for their cash flows and carefully (skillfully) match those asset cash flows with the plan’s liability cash flows to secure the promised benefits. There are many benefits from restructuring the fixed income allocation including improving the plan’s liquidity profile, removing interest rate risk from that portion of the pension plan, while also extending the investing horizon (buy time) for the plan’s other assets to now grow unencumbered. Many in our industry haven’t had to manage through a rising interest rate environment that lasted more than a few quarters. It is a new day! Are you prepared?