By: Russ Kamp, Managing Director, Ryan ALM, Inc.
Pension Obligation Bonds (POBs) were all the rage in 2021 following the historic collapse in US interest rates during the initial market reaction to Covid-19. You may recall that I wrote and spoke quite often on the subject, especially in 2021 and into 2022. We published “POBs – All the Rage!” in early September 2021 and followed that up with “Why POBs? Reason #2 – Reversion to the Mean” later that same month. I was imploring plan sponsors and their advisors to take advantage of the historically low rates, but more importantly, as you’ll read in the second piece, I was concerned about the extraordinary performance results that had been generated by public equities, which I didn’t think were sustainable. As you know, 2022 produced a -18.1% return for the S&P 500, while the BB Aggregate Bond Index declined a historic -13.0%.
If plan sponsors had issued POBs to shore up the plan’s economics, they could have capitalized on an interest rate environment that we are not likely to witness again. According to S&P, there were 72 POBs issued in 2021, which significantly eclipsed the average annual issuance of 25, but given the 20,000+ defined benefit plans, the 72 didn’t register as even a rounding error. What a wasted opportunity! Well, all may not be lost. As the chart below reflects, US interest rates for maturities 5 years and out have seen little increase in the last 12 months despite very aggressive tightening by the Fed.
It is incredible to see just how little movement there has been in the longer-dated Treasury yields. Plan sponsors can still capture an impressive arbitrage opportunity by issuing POBs in this environment. Importantly, the proceeds can be invested in a cash flow matching (CFM) strategy that will secure the plan’s benefits and expenses as far into the future as the POB proceeds will permit. This CFM portfolio will invest in investment-grade corporate bonds that will currently provide a yield to worst (YTW) in the low 5% range. While the CFM portfolio’s assets are used to fund all of the benefits, the plan’s legacy assets can be invested more aggressively now that the plan has bought considerable time (extended the investing horizon). Given the market’s poor performance since the end of 2021, being able to invest at substantially lower valuation levels should be pursued with vigor.
POBs were panned by certain entities because of the uncertainty of investing the bond’s proceeds into a traditional asset allocation. We’ve removed that uncertainty by recommending that the proceeds be used to defease a plan’s liabilities. No reason to play the markets with all of the risk and uncertainty that accompanies that strategy. Please consider POBs again.