Total Return vs. Cash Flow Matching Strategies… a Ying Yang!

By: Ron Ryan, CEO, Ryan ALM, Inc.

Most fixed-income managers are required to outperform a generic market index benchmark. Usually, it is one of the Lehman, now Bloomberg Barclay’s (BB), indexes designed by Ron Ryan when he was the Lehman Director of Fixed Income Research from 1997-1983. As a result, fixed-income managers have to be concerned and focused on anything that affects the pricing of these bonds such as:

  1. Interest rate sensitivity – bonds are extremely interest rate sensitive which usually accounts for over 90% of their total return. Interest rates are extremely volatile and uncertain not only in levels but in the shape or slope of the yield curve. Speculating on interest rates has been a difficult, if not a losing proposition, for many bond managers so they tend to become closet index fund managers by not straying from the interest rate sensitivity of these indexes… like doing key rate duration matching.
  2. Credit ratings – This is a daunting and constant vigil exercise. S&P, Moody’s, and Fitch tend to upgrade and downgrade 100s of credit ratings each year. Such credit changes lead to bond price changes and total return effects. Fortunately, this volatility of credit changes has not been translated into defaults in the investment-grade corporate bond universe. According to the S&P 2022 Global Default Study, there have been only 4 investment grade defaults since 2010. However, bonds have historically been downgraded to high-yield status (BB, B, CCC) before going into default status.
  3. Call features – since bonds were in a bull market from 1982 thru 2021, many bonds are priced at a premium and are targets of being called. This will reduce the yield and the total return of these bonds.

Total return volatility is in sharp contrast to what Cash Flow Matching (CFM) or Cashflow Driven Investments (CDI) strategies are focused on. CDI is focused on funding benefits in a cost-efficient manner with prudent risk. Benefits are future value payments and as such… benefits are not interest rate sensitive. CDI’s concerns are liquidity and solvency. Liquidity is produced by creating monthly cash flows (interest and principal) that match and fund monthly liability cash flows (benefits + expenses). Fortunately, solvency is a hallmark of investment-grade bonds as the S&P study proves. Ryan ALM further assures solvency thru a series of credit filters such as:

  1. Must be investment grade in the Bloomberg Default Probability rankings
  2. NO YTM outliers of >2 STDs from other credits with similar maturities
  3. NO negative watch or outlook on Moody’s, S&P, and Fitch
  4. NO Baa3 or BBB- bonds

If the true objective of a pension is to fund benefits in a cost-efficient manner with prudent risk… then the Ryan ALM cash flow matching product (Liability Beta Portfolio™) is the best fit.

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