By: Russ Kamp, Managing Director, Ryan ALM, Inc.
I suspect that most participants in the capital markets are aware of the implications of rising US inflation and the impact it has had on US interest rates so far in 2022. The US Federal Reserve has certainly raised awareness by twice elevating the Federal Funds Rate by a total of 75 basis points so far with a clear message that more is to come. Perhaps much more! What might be less apparent to the average investor is the impact of widening corporate credit spreads relative to Treasury securities.
My colleague and Ryan ALM’s Head Trader, Steven DeVito, has put together the following chart highlighting the major widening (yield change in the right two columns) that has occurred this year:
What we have witnessed so far is a widening of AA versus comparable Treasuries, but more important is the credit spread widening of BBBs versus AA. What was a 58 bps difference has ballooned to 90 bps as of last Friday. This action can have a profound impact on total return bond programs especially if there is a need for liquidity in the portfolio. On the other hand, credit spread widening has little to no impact on existing cash flow matching portfolios as the bonds are held to maturity.
On a positive note, wider spreads reduce the cost of defeasing pension liabilities when constructing new portfolios. As we’ve mentioned in previous blog posts, higher US interest rates and wider corporate credit spreads are creating an environment in which the cost to defease a pension liability stream is falling and in some cases, depending on the maturity of the program, quite significantly! We’ve just created a Liability Beta Portfolio™ for an SFA recipient that covers 30-years (to 2051) and generates a >40% savings on the cost of those future benefit payments. Who wouldn’t be pleased with that result?
Steve has promised to continue to monitor this widening situation. It will be interesting to see how high US interest rates go and just how wide the corporate spreads get. We may be able to provide benefit security for pennies on the $.
Hi Russ: Then is it correct in saying when interest rates were so low ,it was
making it very difficult for pension funds to meet current and future liabilities? Now with rates rising it will be easier for them. But isn’t the trade off with inflation through the roof offsetting this gain in with the funds having other liabilities so high it needs more contributions to stay in business ?
Good morning, Joe. I hope that you are well today. First, the 39-year bull market in bonds that was fueled by falling interest rates propped up equities, real estate, and other assets that drove incredible returns for the capital markets, including bonds, during the last 4 decades. It was an historic time. Despite great returns on assets, pension liabilities grew substantially because they are bond-like in nature and the present value of those future promises grew substantially, too. The reversal in US interest rates will likely negatively impact most asset classes. We can hope that a substantial rise in rates will impact the liability side of the pension equation more than the asset side. But, pension plans which tend to only focus on assets need to do a much better job of looking at assets versus plan liabilities. Your concern about inflation is appropriate. This situation, which we’ve really not seen in 4 decades is what is driving rates higher and asset valuations lower. Pension liabilities are likely to be impacted to a greater extent than assets given the longer duration/maturity and greater interest rate sensitivity. I hope that I haven’t confused you. Don’t hesitate to follow-up with additional questions/concerns. Russ
Good Morning Russ; Your knowledge and understanding is incredible. I’ve learned that as a lay person pension funds are a lot more complicated than we think. You just don’t make contributions earn a return for a person’s benefits then sit back and relax. Thank you Joe
Good morning, Joe. I’ve been blessed to be in this industry for 40-years, which certainly helps my understanding. Managing a pension system has been made more complicated through the years because plans have relied more on capital market returns than on contributions. Pensions could be simple: take a present value (PV) calculation of your future benefits, contribute enough to meet that obligation, and then sit back and pay those obligations when due. We of course don’t do that. We “assume” a rate of return that the assets are going to earn and calculate the difference that needs to be contributed. If the asset return falls short more needs to be contributed and vice versa. We’ve also invested in many much more complicated products designed to provide greater uncorrelated returns, but they don’t always work as advertised. I believe that there is a happy medium between certainty (but expensive) and the strategy used today that comes with a lot of uncertainty. Have a great day. Russ