By: Russ Kamp, Managing Director, Ryan ALM, Inc.
We all know that 2022 was a terrible year for total return-seeking (TRS) bond managers. In fact, it was the worst year by far since the creation of the Lehman Aggregate Index more than 4+ decades ago. Rising interest rates will do that to bond managers whether your duration is shorter or longer than the index. By the end of the calendar year 2022, the Aggregate Index had declined -13.01%, far eclipsing the -2.9% produced in 1994. Furthermore, it was only the fifth negative total return recorded in the Index’s history. That is a pretty amazing achievement.
What is happening in 2023? January was a terrific month as US interest rates fell in anticipation of a Federal Reserve that was going to moderate its increases in the Fed Funds Rate (FFR). For the month, the Aggregate Index rose +3.08%. A far cry from the activity of the previous 12 months. However, the celebration didn’t last too long, as January’s fine performance was quickly replaced by a -2.59% February. The economic environment hadn’t calmed down to any great extent and the anticipation that the moderation in FFR increases would be replaced by a pause or the “Great Pivot” proved to be illusionary.
So, at this point, we have a Fed that continues to promise further increases in the FFR (5.375% is the current target with a projected terminal rate at 7.0%!) and an inflationary environment that isn’t close to falling back to the 2% target that they have established. With a historic labor market and rising wages, it doesn’t appear that inflation will be contained in the near future. This environment will continue to prove challenging for TRS managers to provide a positive return despite the much higher yields offsetting principal losses.
We once again ask the question: Why don’t you de-risk your pension system’s exposure to fixed income by migrating the core total return-seeking mandates to cash flow matching assignments? This action will SECURE the promised benefits as far into the future as the allocation will cover while mitigating interest rate risk for that portion of the portfolio. Furthermore, you have now bought time for the plan’s alpha assets to grow unencumbered, as they are no longer a source of liquidity. This eliminates the common practice of sweeping cash from all assets to fund benefits (B) + expenses (E). Let your bond allocation pay B+E.
Great uncertainty exists within the US markets – both bond and stock – as a result of the Fed’s actions. Why gamble that we are close to the end of their activity? Secure the promises through cash flow matching B+E and let yourself and your participants sleep well at night knowing that markets won’t crush their promised benefits.