By: Russ Kamp, Managing Director, Ryan ALM, Inc
Everyone knows that this has been a very challenging year for traditional fixed-income programs. In fact, it has been the most challenging year in the past 40-years. As of yesterday, May 16, 2022, the Bloomberg Barclays Aggregate index is down -9.52% YTD. With US Treasury yields rising across the yield curve today, that Agg index will be off some more. It still seems like everyone uses the Aggregate index as the primary benchmark to compare Core and Core+ fixed income managers. As a reminder, my colleague, Ron Ryan, created the index back in the ’80s when he was the Director of Research at Lehman Brothers.
What does the index look like today? The Aggregate is a very large and diversified portfolio of bonds with the following summary statistics as of March 31, 2022:
|# of issues||9,982||Treasury||39.80%||AAA||68.92%|
|Duration||6.58 yrs.||Mtg. Backed||29.90%||A||11.16%|
|Avg Maturity||8.78 yrs.||Corporates||26.30%||BBB||15.38%|
This poor performance result has been created despite the heavy emphasis on AAA-rated securities and a fairly modest duration of only 6.58 years. As a result of the higher quality emphasis, the yield to maturity (YTM) is only 2.92%. If the US Federal Reserve is true to its recent pronouncements, there is likely much more pain ahead for both fixed income advisors and plan sponsors. In addition to the potentially large negative return, fixed income portfolios are a source to fund benefits and expenses. Because most traditional fixed income products are return-focused and not cash flow matched to the pension system’s liability cash flows, bonds in these accounts will likely be sold at losses and this cost to transact may escalate in a rising rate environment where liquidity is not abundant.
Now, let’s compare that scenario to a cash flow matched portfolio used to SECURE the promised benefits. Ryan ALM just constructed a cash flow matched portfolio for a multiemployer plan that is expecting to receive SFA grant assets. The size of the allocation and the current rising interest rate environment allowed us to fully defease 29-years of benefit payments with the SFA proceeds! A homerun! Furthermore, the YTM of our portfolio is 4.68%, or 176 bps greater than the yield on the Aggregate index. Although the modified duration is slightly longer at 8.84 years, our portfolio is defeasing future values (benefit payments) that are not interest-rate sensitive. The plan’s liabilities and these assets will move in lockstep. That is certainly not guaranteed when using a traditional total return fixed income mandate.
Those advantages alone are incredible and certainly favor using a cash flow matching strategy to secure the promised benefits, but when you also factor in the greater liquidity (no forced selling) and the “buying” of time for the remainder of your assets to wade through choppy markets, the decision to use a cash flow matching strategy instead of a total return mandate becomes a no-brainer.