05.23.25
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AAA Bonds… A Time That Was

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

The first bond indexes were invented by Art Lipson, my boss, at Kuhn Loeb in the summer of 1973. At that time, the bond market was dominated by AAA Government and corporate bonds. The Kuhn Loeb Government bond index was 100% AAA, and the Kuhn Loeb corporate bond index structure was:    

AAA = 37%    AA = 25%    A = 32%    BBB= 5%

Given the recent downgrade by Moody’s of Treasuries to Aa1 from Aaa we now have an investment grade structure with almost the absence of AAA bonds as evidenced by the Bloomberg Aggregate index:  

AAA = 3.1%   AA = 47.9%   A = 11.4%   BBB = 11.4%   NR = 20.8%   Other = 5.4%

Treasuries and Agencies = 46.08% of the Aggregate index and this exposure will likely grow due to the growing US deficit. This suggests that the Aggregate index yield spread versus A/BBB corporate bonds should widen over time. The Bloomberg Corporate bond index structure is now heavily skewed to A and BBB bonds:  

AAA = 1.1%   AA = 6.3%    A = 45.2%    BBB = 44.9%  Other = 2.6%.

The pension ROA hurdle rate has been in a downward trend for some time and is currently around 6.50% to 7.00% for most pensions. Notably, the ROA is actually a series of ROAs for each asset class weighted to arrive at a single total ROA. The yield of the Bloomberg Aggregate is usually the projected ROA for bonds. The Ryan ALM cash flow matching (CFM) model (we call the Liability Beta Portfolio™  or LBP) will outyield the Aggregate by 50 – 100 basis points depending on the average maturity since it is a corporate bond portfolio skewed to A/BBB+ credits. This means that the LBP will enhance the ROA as shown below which may reduce Contribution costs as well:

                                                    Yield            Weight      ROA          Weight     ROA          Weight     ROA

Bloomberg Aggregate           4.50%             20%       0.90%         30%     1.35%           40%      1.80%

      Ryan ALM LBP                    5.50%             20%       1.10%          30%     1.65%           40%      2.20%

Ryan ALM highly recommends that pensions transfer their current core bond allocations to CFM. The benefits of our LBP are significant and numerous:

  1. LBP matches and fully funds monthly B+E thereby securing the benefits
  2. Enhances ROA by out-yielding index benchmark for fixed income
  3. Provides liquidity to fully fund B+E so no need for cash sweep
  4. Best inflation hedge since it funds actuarial B+E projections
  5. Focuses on actuarial FVs thereby mitigating interest rate risk
  6. By matching FVs CFM should also duration match liabilities
  7. Reduces funding costs by 2% per year = 20% on 1-10 years 
  8. Reduces asset management costs (Ryan ALM fee = 15 bps)
  9. Reduces volatility of the funded ratio + contributions
  10. Buys time for Alpha assets to grow unencumbered

Remember:  the pension objective should be to fully fund and secure the promised benefits in a cost-efficient manner with prudent risk.

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