By: Ronald J. Ryan, CFA, CEO, Ryan ALM, Inc.

Q: What is the Value of Bonds?

A:  The certainty of their Cash Flows!

Bonds are, perhaps, the only asset class with the certainty of their cash flows.

You know with near certainty (excluding any defaults) the semi-annual interest payments and the principal payment at maturity (for non-callable bonds). That is why non-callable bonds have a long and proven history of being chosen as the proper fit to defease and cash flow match liability cash flows. 

Ryan ALM urges pensions, OPEBs, and any other asset base with a liability-driven objective to use bonds for their intrinsic value. We do not view or recommend bonds as performance vehicles even though they can certainly outperform other asset classes when interest rates are going down as a secular trend (i.e. 1982 – 2021). We urge asset allocation models to separate liquidity (cash flow) assets from growth (alpha) assets. Use bonds as your liquidity assets to match and fund liability cash flows chronologically… especially with today’s inverse yield curve. This will BUY TIME for the alpha assets to grow unencumbered. Importantly, this will eliminate the CASH SWEEP of other asset classes that reduce their total returns (ROA). According to a Guinness Asset Management study, about 50% of the S&P 500 10-year rolling average returns since 1940 come from dividends and the reinvestment of those dividends. 

Since contributions are the first source to fund benefits and expenses (B+E), current assets need to fund NET liability cash flows. For many pensions, contribution costs are large so net liabilities are a much less onerous cash flow to fund. In many pensions, just a 15% allocation to bonds can fund 1-7 years of B+E. This is a better use for bonds than any performance target. The longer the period funded by bonds, the greater the probability of achieving high rates of returns on the growth assets. Liquidity and growth assets should be a synergistic team that when working together achieves the cash flow requirements and the ROA target and SECURES the promised benefits.

We haven’t had an interest rate environment as positive as this in a long time. Use the higher rates to your advantage by taking risks off the table through a defeasement strategy. Everyone will sleep much better.