Tag Archives: bonds

03.20.25
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FOMC and Powell Deliver Worrying Message

By: Russ Kamp, CEO, Ryan ALM, Inc.

I produced a post recently titled, “Parallels to the 1970s?” in which I discussed the challenging economic environment that existed during the 1970s as a result of two oil shocks and some sketchy decision making on the part of the US Federal Reserve. The decade brought us a new economic condition called stagflation, which was a term coined in 1965 by British politician Lain Macleod, but not widely used or recognized until the first oil embargo in 1973. Stagflation is created when slow economic growth and inflation are evident at the same time.

According to the graph above, the FOMC is beginning to worry about stagflation reappearing in our current economy, as they reduced the expectations for GDP growth (the Atlanta Fed’s GDPNow model has Q1’25 growth at -1.8%), while simultaneously forecasting the likelihood of rising inflation. Not good. If you think that the FOMC is being overly cautious, look at the recent inflation forecasts from several other entities. Seems like a pattern to me.

Yet, market participants absorbed the Powell update as being quite positive for both stocks and bonds, as markets rallied soon after the announcement that the FOMC had held rates steady. Why? There is great uncertainty as to the magnitude and impact of tariffs on US trade and economic growth. If inflation does move as forecasted, why would you want to own an active bond strategy? If growth is moderating, and in some cases forecasted to collapse, why would you want to own stocks? Aren’t earnings going to be hurt in an environment of weaker economic activity? Given current valuations, despite the recent pullback, caution should be the name of the game. But, it seems like risk on.

Given the uncertainty, I would want to engage in a strategy, like cash flow matching (CFM), that brought an element of certainty to this very confusing environment. CFM will fully fund the liability cash flows (benefits and expenses) with certainty providing timely and proper liquidity to meet my near-term obligations, so that I was never in a position where I had to force liquidity where natural liquidity wasn’t available. Protecting the funded ratio of my pension plan would be a paramount objective, especially given how far most plans have come to achieve an improved funding status.

I’ve written on many occasions that the nearly four decades decline in rates was the rocket fuel that drove risk assets to incredible heights. It covered up a lot of sins in how pensions operated. If a decline in rates is the only thing that is going to prop up these markets, I doubt that you’ll be pleased in the near-term. Bifurcate your assets into two buckets – liquidity and growth – and buy time for your pension plan to wade through what might be a very challenging market environment. The FOMC was right to hold rates steady. Who knows what their next move will be, but in the meantime don’t bet the ranch that inflation will be corralled anytime soon.

02.13.25
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Nothing Here! Really?

By: Russ Kamp, CEO, Ryan ALM, Inc.

Yesterday’s financial news delivered an inflation surprise (0.5% vs. 0.3%), at least to me and the bond market, if not to the U.S. equity market. The Federal reserve had recently announced a likely pause in their rate reduction activity given their concerns about the lack of pace in the inflation march back to its 2% target. This came on the heels of “Street” expectations after the first 0.5% cut in the FFR that there were “likely” to be eight (8!) interest rate cuts by the summer of 2025. Oh, well, the two cuts that we’ve witnessed since that first move last September may be all we get for a while. “Ho hum” replied the U.S. stock market.

The discounting of yesterday’s inflation release is pretty astounding. Like you, I’ve read the financial press and the many emails that have addressed the CPI data 52 ways to Sunday. Much of the commentary proclaims this data point as a one-off event. For instance, the impact of egg price increases (13.8% last month alone) is temporary, as bird flu will be contained shortly. Seasonal factors impacting “sticky-priced” products tend to be announced in January. I guess those increases shouldn’t matter since they only impact the consumer in January. As a reminder, Core inflation (minus food and energy) rose from 3.1% to 3.3% last month. That seems fairly significant, but we are told that the other three core readings were down slightly, so no big deal. Again, really? Each of those core measures are >3% or more than 1% greater than the Fed’s target.

Then there are those that say, “what is significant about the Fed’s 2% inflation objective anyway”? It is an arbitrary target. Well, that may be the case, but for the millions of Americans that are marginally getting by, the difference between 2% and 3% inflation is fairly substantial, especially when we come up with all of these measures that exclude food, energy, housing (shelter), etc. Are you kidding?

As mentioned previously, expectations for a massive cut in interest rates due to the perception that inflation was well contained have shifted dramatically. Just look at the graph above (thanks, Bloomberg). Following the Fed’s first FFR cut of 50 bps, inflation expectations plummeted to below 1.5% for the two-year breakeven. Today those same expectations reveal a nearly 3.5% expectation. Rising inflation will certainly keep the Fed in check at this time.

As mentioned earlier in this post, U.S. equities shrugged off the news as if the impact of higher inflation and interest rates have no impact on publicly traded companies. Given current valuations for U.S. stocks, particularly large cap companies, any inflation shock should send a shiver down the spines of the investing community. Should interest rates rise, bonds will surely become a more exciting investment opportunity, especially for pension plans seeking a ROA in the high 6% area. How crazy are equity valuations? Look at the graph below.

The current CAPE reading has only been greater during the late 1990s and we know what happened as we entered 2000. The bursting of the Technology bubble wasn’t just painful for the Information Technology sector. All stocks took a beating. Should U.S. interest rates rise as a result of the current inflationary environment, there is a reasonable (if not good) chance that equities will get spanked. Why live with this uncertainty? It is time to get out of the game of forecasting economic activity. Why place a bet on the direction of rates? Why let your equity “winnings” run? As a reminder, managing a DB pension plan should be all about SECURING the promised benefits at a reasonable cost and with prudent risk. Is maintaining the status quo prudent?

01.22.25
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It May Not Be the Iron Gwazi, But…

By: Russ Kamp, CEO, Ryan ALM, Inc.

I was fortunate to enter the investment industry in October 1981. The 10-year Treasury note’s yield was around 15% at that time. U.S. interest rates would fall (collapse?) for most of the next four decades until they bottomed during the beginning of Covid-19. Oh, it was great to be a bond manager during those decades. You could basically be long duration relative to the Aggregate index with little worry that rates would rise. It was a time to “mint” money in fixed income. Then, it wasn’t!

The beginning of Covid-19 brought about a substantial reaction to the collapse of our economy through major federal stimulus programs. The historic infusion of financial support created excess demand for goods and services at the same time that many of those services were temporarily restricted. The result was the worst inflation shock since the 1970s, which led to the double digit yields mentioned above.

It wasn’t surprising that inflation would appear after decades of it being well contained. It was perhaps the magnitude (9.1% inflation at the peak) of the move that grabbed everyone’s attention. For bond managers, the revival of inflation created an environment that forced the U.S. Federal Reserve to initiate the most aggressive policy shift in quite some time beginning in March 2022. As a result of the Fed’s action, bond managers suffered their worst year ever as represented by the BB Aggregate Index (-13%). The average fixed income manager faired only slightly better than the index according to eVestment’s database, as the median core bond manager produced a -12.8% result for all of 2022.

The following two years have been incredibly volatile for U.S. bond managers. Calendar year 2023 was looking to be a very poor year until the investing community was certain that the Fed had accomplished its objective by the end of that year, and as a result, interest rates fell. For the year, the median fixed income manager was up 6.1%, or a little bit less than 1/2 what they had lost in the previous year. This past year was no better, except that markets were rosier to begin 2024, only to have a challenging conclusion to the year as inflation proved much stickier. The median manager produced only a 2% return for the year, holding on to <1/2 the income while seeing principal losses. Given the topsy turvy nature of the bond market during the last three years, it shouldn’t come as a surprise that the median manager has only generated a -1.9% 3-year annualized result.

The rollercoaster of fixed income returns observed during the last several years may not be as extreme as those we witness in other asset classes, mainly equities, but it is not helpful to the long-term funding of pension plans or endowments and foundations. As most know, changes in interest rates are the greatest risk to fixed income strategies. The 4-decade decline in rates was preceded by a nearly 3-decade rise in rates beginning in the early 1950s. Does the significant rise in rates starting in 2022 mark the beginning of another long-term secular upward trend or is this just a head fake? I wouldn’t want to have to bet on the future of interest rates in order to manage a successful program and you shouldn’t either.

Cash flow matching (CFM) mitigates interest rate risk. The defeasing of benefit payments, which are future values, are not interest rate sensitive since a $1,000 monthly payment in the future is $1k whether rates rise or fall. Furthermore, the cost savings that are produced on the day that the CFM portfolio is built will be maintained whether rates rise or fall. We are seeing at least a -2% reduction in cost per year in our model. Ask us to defease your benefit payments for 10 years and you’ll see a roughly 20% reduction. Longer-term programs (such as 30-years) can see substantial cost savings and annual reductions >-2%/year.

So, I ask, why invest in a core bond product, the success of which is predicated mostly on the direction of interest rates, when one can invest in a CFM strategy that provides the certainty of cash flows to meet benefit payments? Furthermore, CFM portfolios mitigate interest rate risk and extend the investing horizon for your plan’s alpha (growth) assets, while getting you off the rollercoaster of annual returns. Lastly, given the recent rise in U.S. interest rates, building a CFM portfolio with investment grade corporate bonds can produce a YTW of 5.5% or better. Seems like a sleep well at night strategy to me.

BTW, the Iron Gwazi is the world’s steepest and fastest hybrid rollercoaster found at Busch Gardens in Florida. It has a height of 206 feet and a 91 degree drop. It might just rival the feeling one got going through the Great Financial Crisis. That wasn’t any fun!

01.14.25
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Hey, Pension Community – We Have Liftoff!

By: Russ Kamp, CEO, Ryan ALM, Inc.

Not since October of 2023 have we seen long-dated Treasury yields at these levels. Currently, the 30-year Treasury bond yield is 5% (12:47 pm EST) and the 10-year Treasury Note’s yield has eclipsed 4.8%. Despite tight credit spreads, long-dated (25+ years) IG corporate bond yields are above 6% today (chart in the lower right corner).

Securing pension liabilities, whether your DB plan is private, public, or a multiemployer plan, should be the primary objective. All the better if that securing (defeasement strategy) can be accomplished at a reasonable cost and with prudent risk. The good news: the current rate environment is providing plan sponsors with a wonderful opportunity to accomplish all of those goals, whether you engage in a cash flow matching (CFM) for a relatively short period (5-years), intermediate, (10ish-years) or longer-term (15- or more years) your portfolio of IG corporate bonds will produce a YTM of > 5.5%. This represents a significant percentage of the target ROA.

Furthermore, as we’ve explained, pension liabilities are future values (FVs), and FVs are not interest rate sensitive. Your portfolio will lock in the cost savings on day one, and barring any defaults (about 2/1,000 in IG bonds), the YTM is what your portfolio will earn throughout the relationship. That is exciting given the fact that traditional fixed income core mandates bleed performance during rising rate regimes. In fact, the IG index is already off 1.2% YTD (<10 trading days).

Who knows when the high equity valuations will finally lead to a repricing. Furthermore, who knows if US inflation will continue to be sticky, the Fed will raise or lower rates, geopolitical risks will escalate, and on and on. With CFM one doesn’t need a crystal ball. You can SECURE the promised benefits for a portion of your portfolio and in the process you’d be stabilizing the funded status and contribution expenses associated with those assets. Don’t let this incredibly attractive rate environment come and go without doing anything. We saw inertia keep plans from issuing POBs when rates were historically low. It is time to act.

01.07.25
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Will You Do Nothing?

By: Russ Kamp, CEO, Ryan ALM, Inc.

I recently read an article by Cliff Asness of AQR fame, titled “2035: An Allocator Looks Back over the Last 10 Years”. It was written from the perspective that performance for world markets was poor and his “fund’s” performance abysmal during that 10-year timeframe. His take-away: we can always learn from our mistakes, but do we? He cited some examples of where he and his team might have made “mistakes”, including:

Public equity – “It turns out that investing in U.S. equities at a CAPE in the high 30s yet again turned out to be a disappointing exercise”.

Bonds – “Inflation proved inertial” running at 3-4% for the decade producing lower real returns relative to the long-term averages.

International equities – “After being left for dead by so many U.S. investors, the global stock market did better with non-U.S. stocks actually outperforming”.

Private equity – “It turned out that levered equities are still equities even if you only occasionally tell your investors their prices”. When everyone is engaged in pursuing the same kind of investment there is a cost.

Private credit – “The final blow was when it turned out that private credit, the new darling of 2025, was just akin to really high fee public credit” Have we learned nothing from our prior CDO debacle?

Crypto – “We had thought it quite silly that just leaving computers running for a really long time created something of value”. “But when Bitcoin hit $100k we realized that we missed out on the next BIG THING” (my emphasis) “Today, 10 after our first allocation and 9 years after we doubled up, Bitcoin is at about $10,000.”

Asness also commented on active management, liquid alts, and hedge funds. His conclusion was that “the only upside of tough times is we can learn from them. Here is to a better 2035-2045”

Fortunately, you reside in the year 2025, a year in which U.S. equities are incredibly expensive, U.S. inflation may not be tamed, U.S. bonds will likely underperform as interest rates rise, the incredible push into both private equity and credit will overwhelm future returns, and let’s not discuss cryptos, which I still don’t get. Question: Are you going to maintain the status quo, or will you act to reduce these risks NOW before you are writing your own 10 year look back on a devastating market environment that has set your fund back decades?

As we preach at Ryan ALM, Inc., the primary objective when managing a DB pension plan is to SECURE the promised benefits at a reasonable cost and with prudent risk. Continuing to invest today in many segments of our capital markets don’t meet the standard of low cost or of a prudent nature. Now is the time to act! It really doesn’t necessitate being a rocket scientist. Valuations matter, liquidity is critical, high costs erode returns, and no market outperforms always! Take risk off the table, buy time for the growth assets to wade through the next 10-years of choppy markets, and SECURE the promised benefits through a cash flow matching (CFM) strategy that ensures (barring defaults) that the promised benefits will be paid when due.

Thanks, Cliff, for an excellent article!

12.19.24
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5.6% 10-year forecast for US All-Cap

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Fiducient Advisors has published its 2025 Outlook. Given the strong performance in US equity markets, future returns have been adjusted downward – rightfully so. Here are some of the highlights:

–Full valuations, concentrated U.S. large-cap indexes and the risk of reigniting inflation are shaping the key themes we believe will drive markets and portfolio positioning in 2025.

-Recent market successes have pushed our 2025 10-year forecasts lower across most major asset classes. Long-term return premium for equities over fixed income is now at its narrowest since 2007, sparking important conversations about portfolio posture and risk allocation.

–Rising reinflation risk leads us to increase our allocation to more flexible fixed income strategies (dynamic bonds) and TIPS while eliminating our global bond allocation.

US stock market performance has been heavily influenced by the “Magnificent Seven”, creating concentration risk not seen in decades, if ever. The outperformance of US markets vis-a-vis international markets is unprecedented. As stated above, valuations are stretched. Most metrics used to measure “value” in our markets are at extreme levels, if not historical. How much more can one squeeze from this market? As a result, Fiducient is forecasting that US All-Cap (Russell 3000?) will appreciate an annualized 5.6% for the next 10-years.

Nearly as weak are the forecasts for private equity, which Fiducient believes will produce only an annualized 8.6% return through the next 10-years. What happened to the significant “premium” that investing privately would provide? Are the massive flows into these products finally catching up with this asset class? Sure seems like it.

With regard to the comment about fixed income, I’m not sure that I know what “flexible fixed income strategies” are and the reference to dynamic escapes me, too. I do know that bonds benefit from lower interest rates and get harmed when rates rise. We have been very consistent in our messaging that we don’t forecast interest rates as a firm, but we have also written extensively that the inflation fight was far from over and that US growth was more likely to surprise on the upside than reflect a recessionary environment. Today, the third and final installment of the Q3’24 GDP forecast was revised up to 3.1% annual growth. The Q4’24 estimate produced by the Atlanta Fed through its GDPNow model is forecasting 3.2% annual growth. What recession?

Given that US growth is likely to be stronger, employment and wage growth still robust, and sticky inflation just that, bonds SHOULDN’T be used as a performance instrument. Bonds should be used for their cash flows of interest and principal. BTW, one can buy an Athene Holding Ltd (ATH) bond maturing 1/15/34 with a YTW of 5.62% today. Why invest in US All-Caps with a projected 5.6% return with all of that annual standard deviation when you can buy a bond, barring a default and held to maturity, will absolutely provide you with a 5.62% return? This is the beauty in bonds! Those contractual cash flows can be used, and have been for decades, to defease liabilities (pension benefits, grants, etc.) and to SECURE the promises made to your participants.

It is time to rethink the approach to pension management and asset allocation. Use a cash flow matching strategy to secure your benefits for the next 10-years that buys time for the growth assets to GROW, as they are no longer a source of liquidity. Equity markets may not provide the same level of appreciation as they have during the last decade (+13.4% annualized for the S&P 500 for 10-years through 11/30/24), but a defeased bond portfolio will certainly provide you with the necessary liquidity, an extended investing horizon, and the security (peace of mind) of knowing that your benefits will be paid as promised and when due! Who needs “flexible and dynamic” bonds when you have the security of a defeased cash flow matching strategy?

10.21.24
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What Will Their Performance be? Continued

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

I recently published a post titled, “What Will Their Performance be in About 11 Years?” I compared the Ryan ALM, Inc. cash flow matching (CFM) strategy to a relative return fixed income manager, and I raised the question about future performance. Barring any defaults within the investment grade universe, which historically average about 2/1,000 bonds, we can tell you on day one of the portfolio’s construction what the performance will be for the entire period of a CFM mandate.

In my previous post, I stated, “now, let me ask you, do you think that a core fixed income manager running a relative return portfolio can lay claim to the same facts? Absolutely, not! They may have benefitted in the most recent short run due to falling interest rates, but that future performance would clearly depend on multiple decisions/factors, including the duration of the portfolio, changes in credit spreads, the shape of the yield curve, the allocation among corporates, Treasuries, agencies, and other bonds, etc. Let’s not discount the direction of future interest rate movements and the impact those changes may have on a bond strategy. In reality, the core fixed income manager has no idea how that portfolio will perform between now and March 31, 2035.

Whatever benefit the active relative-return fixed income manager might have gotten from those declining rates earlier this year has now been erased, as Treasury yields have risen rapidly across all maturities since the Fed announced its first cut in the FFR. Including today’s trading, the US 10-year Treasury note yield has backed up 67 bps since the yield bottomed out at 3.5% in mid-September (currently 4.17% at 11:40 am). The duration of the 10-year note is 8.18 years, as of this morning. That equates to a loss of principal of -5.48% in roughly 1 month. Wow!

Again, wouldn’t you want the certainty of a CFM portfolio instead of the very uncertain performance of the relative return fixed income manager? Especially when one realizes that the active fixed income manager’s portfolio won’t likely cover the liquidity needed to meet benefits and expenses. Having to “sell” bonds in a rising rate environment locks in losses for the active manager, while the CFM portfolio is designed to meet ALL of the liquidity through maturing principal and income – no selling. This seems like a no-brainer!

10.08.24
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We Suggested That It Might Just Be Overbought

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Regular readers of this blog might recall that on September 5th we produced a post titled, “Overbought?” that suggested that bond investors had gotten ahead of themselves in anticipation of the Fed’s likely next move in rates. At that time, we highlighted that rates had moved rather dramatically already without any action by the Fed. Since May 31, 2024, US Treasury yields for both 2-year and 3-year maturities had fallen by >0.9% to 9/5. By almost any measure, US rates were not high based on long-term averages or restrictive.

Sure, relative to the historically low rates during Covid, US interest rates appeared inflated, but as I’ve pointed out in previous posts, in the decade of the 1990s, the average 10-year Treasury note yield was 6.52% ranging from a peak of 8.06% at the end of 1990 to a low of 4.65% in 1998. I mention the 1990s because it also produced one of the greatest equity market environments. Given that the current yield for the US 10-year Treasury note was only 3.74% at that point, I suggested that the present environment wasn’t too constraining. In fact, I suggested that the environment was fairly loose.

Well, as we all know, the US Federal Reserve slashed the Fed Funds Rate by 0.5% on September 18th (4.75%-5.0%). Did this action lead bond investors to plow additional assets into the market driving rates further down? NO! In fact, since the Fed’s initial rate cut, Treasury yields have risen across the yield curve with the exceptions being ultra-short Treasury bills. Furthermore, the yield curve is positively sloping from 5s to 20s.

Again, managing cash flow matching portfolios means that we don’t have to be in the interest rate guessing game, but we are all students of the markets. It was out thinking in early September that markets had gotten too far ahead of the Fed given that the US economy remained on steady footing, the labor market continued to be resilient, and inflation, at least sticky inflation, remained stubbornly high relative to the Fed’s target of 2%. Nothing has changed since then except that the US labor market seems to be gaining momentum, as jobs growth is at a nearly 6-month high and the unemployment rate has retreated to 4.1%.

There will be more gyrations in the movement of US interest rates. But anyone believing that the Fed and market participants were going to drive rates back to ridiculously low levels should probably reconsider that stance at this time.

10.04.24
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What Will Their Performance Be In About 11 years?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

How comforting would it be for both plan sponsors and their advisors to know how a particular strategy is going to perform over some defined period of time? I would think that having that knowledge would be quite comforting, at least as a “core” holding. Do you think that a core fixed income manager running a relative return strategy versus the Bloomberg Barclays Aggregate Index could tell you how that portfolio will perform in the next 10 1/2 years? No. Ryan ALM can with a very high degree of certainty. How’s that? Well, cash flow matching (CFM) of asset cash flows to liability cash flows locks in that relationship on the day that the portfolio is constructed. Ryan ALM views risk as the uncertainty of achieving the objective. If the true pension objective is to fund benefits and expenses in a cost-efficient manner with prudent risk, then our CFM model will be the lowest risk portfolio.

We were awarded a CFM assignment earlier this year. Our task was/is to defease the future grant payments for this foundation. On the day the portfolio was built, we were able to defease $165.1 million in FV grant payments for only $118.8 million, locking in savings (difference between FV and PV of the liability cash flows) of $46.3 million equal to 28.0% of those future grant payments. That’s fairly substantial. The YTM on that day was 5.19% and the duration was 5.92 years.

Earlier this week, we provided an update for the client through our monthly reporting. The current Liability Beta Portfolio (the name that we’ve given to our CFM optimization process) has the same FV of grant payments. On a market value basis, the portfolio is now worth $129 million, and the PV of those future grant payments is $126 million. But despite the change in market value due to falling interest rates, the cost savings are still -$46.3 million. The YTM has fallen to 4.31%, but that doesn’t change the initial relationship of asset cash flows to liability cash flows. That is the beauty of CFM.

Now, let me ask you, do you think that a core fixed income manager running a relative return portfolio can lay claim to the same facts? Absolutely, not! They may have benefitted in the most recent short run due to falling interest rates, but that would clearly depend on multiple decisions/factors, including the duration of the portfolio, changes in credit spreads, the shape of the yield curve, the allocation among corporates, Treasuries, agencies, and other bonds, etc. Let’s not discount the direction of future interest rate movements and the impact those changes may have on a bond strategy. In reality, the core fixed income manager has no idea how that portfolio will perform between now and March 31, 2035.

Furthermore, will they provide the necessary liquidity to meet those grant payments or benefits and expenses, if it were a DB pension? Not likely. With a yield to maturity of 4.31% and a market value of assets of $129.3 million, they will produce income of roughly $5.57 million/year. The first year’s grant payments are forecast to be $9.7 million. Our portfolio is designed to meet every $ of that grant payment. The relative return manager will be forced to liquidate a portion of their portfolio in order to meet all of the payments. What if rates have risen at that point. Forcing liquidity in that environment will result in locking in a loss. That’s not comforting.

CFM portfolios provide the client with the certainty of cash flows when they are needed. There is no forced selling, unlike the relative return manager that might be forced to sell in a market that isn’t conducive to trading. Furthermore, a CFM mandate locks in the cost savings on day 1. The assets not used to meet those FV payments, can now be managed more aggressively since they benefit from more time and aren’t going to be used to meet liability cash flows.

Asset allocation strategies should be adapted from a single basket approach to one that uses two baskets – liquidity and growth. The liquidity bucket will house a defeased bond portfolio to meet all the cash flow requirements and the remainder of the assets will migrate into the growth bucket where they can now grow unencumbered. You’ll know on day 1 how the CFM portfolio is going to perform. Now all you have to worry about are those growth assets, but you’ll have plenty of time to deal with any challenges presented.

07.09.24
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The Proof’s in the Pudding!

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Not sure why I used the title that I did, but I recently had pudding (vanilla) over the holiday weekend, so maybe that inspired me, and boy, was it good! That said, we, at Ryan ALM, Inc., are frequently challenged about the benefits of Cash Flow Matching (CFM) versus other LDI strategies, most notably duration matching. There seems to be singular focus on interest rate risk without any consideration for the need to create the necessary liquidity to meet monthly benefit payments. Given that objective, it isn’t surprising that duration matching strategies have been the dominant investment strategy for LDI mandates. But does that really make sense?

Are duration matching strategies that use an average duration or several key rate durations along the Treasury curve truly the best option for hedging interest rate risk? There are also consulting firms that espouse the use of several different fixed income managers with different duration objectives such as short-term, intermediate, and long-term duration mandates. Again, does this approach make sense? Will these strategies truly hedge a pension plan’s interest rate sensitivity? Remember, duration is a measure of the sensitivity of a bond’s price to changes in interest rates. Thus, the duration of a bond is constantly changing.

We, at Ryan ALM, Inc., believe that CFM provides the more precise interest rate hedge and duration matching, while also generating the liquidity necessary to meet ongoing benefits (and expenses (B&E)) when needed. How? In a CFM assignment, every month of the mandate is duration matched (term structure matched). If we are asked to manage the next 10-years of liabilities, we will match 120 durations, and not just an “average” or a few key rates. In the example below, we’ve been asked to fund and match the next 23+ years. In this case, we are funding 280 months of B&E chronologically from 8/1/24 to 12/31/47. As you can see, the modified duration of our portfolio is 6.02 years vs. 6.08 years for liabilities (priced at ASC 715 discount rates). This nearly precise match will remain intact as US interest rates move either up or down throughout the assignment.

Furthermore, CFM is providing monthly cash flows, so the pension plan’s liquidity profile is dramatically improved as it eliminates the need to do a cash sweep of interest, dividends, and capital distributions or worse, the liquidation of assets from a manager, the timing of which might not be beneficial. Please also note that the cost savings (difference between FV and PV) of nearly 31% is realized on the day that the portfolio is constructed. Lastly, the securing of benefits for an extended time dramatically improves the odds of success as the alpha/growth assets now have the benefit of an extended investing horizon. Give a manager 10+ years and they are likely to see a substantial jump in the probability of meeting their objectives.

In this US interest rate environment, where CFM portfolios are producing 5+% YTMs with little risk given that they are matched against the pension plan’s liabilities, why would you continue to use an aggressive asset allocation framework with all of the associated volatility, uncertainty, and lack of liquidity? The primary objective in managing a pension plan is to SECURE the promised benefits at a reasonable cost and with prudent risk. It is not an arms race designed on producing the highest return, which places most pension plans on the asset allocation rollercoaster of returns.