Tag Archives: bonds

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.

05.03.24
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He Said What?

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

I’d like to thank Bill Gross for his honest assessment that he just provided on the likely failure of “Total Return” bond products going forward. Here are his thoughts that were summarized in a Bloomberg Business email:

Bill Gross says his “total return” strategy—the one that revolutionized the bond market— “is dead”! Instead of just picking up steady interest payments like his peers did at the time, the co-founder of Pacific Investment Management created the firm’s Total Return Fund in 1987 to take active positions in duration, credit risk and volatility. The idea is that, more than just clipping coupons, bond investors can also benefit from capital appreciation as bond prices rise and yields fall. But in an outlook published Thursday, Gross noted what’s different now is that yields are much lower than when he first coined the concept, leaving investors with less room for price appreciation. 

We’ve been stressing this point for a long time now. Bonds should be used for the certainty of cash flows that they produce of interest and principal. Those cash flows are known and can be modeled with certainty (barring no defaults) to meet the liability cash flows of a pension plan (benefits) or foundation (grants). As Gross rightly points out, given the current level of US interest rates and inflation, just how much appreciation can be achieved, if an investor is on the correct side of a duration bet.

Capital market participants benefited tremendously during the nearly four decades decline in rates from 1981 to 2021. That move down in rates was certainly great for “total return” bond programs, but it also acted as rocket fuel for risk assets. What most market participants have either forgotten or don’t know is the fact that US interest rates trended higher for 28 years prior to the peak achieved in 1981. They are used to the Fed stepping into the fray every time there was a wiggle or wobble in the markets. Well, those days might be behind us.

Yes, US employment came in light this morning with 175k jobs being created in April when the forecast was for 240k, but that is one data point. We certainly witnessed an aggressive move down in rates during 2023’s fourth quarter only to see most of that move reversed to start 2024. Was your bond program able to get both directions correct or did your portfolio get whipsawed? Wouldn’t it be more comforting to know that you can install a cash flow matching portfolio that will SECURE the promises that have been made to the plan participants without having to guess the direction of rates? Even if one were to guess correctly, just how far will rates fall given that inflation remains sticky? Are you likely to see negative real yields?

The US economy remains robust. Fiscal policy remains easy with excessive Government spending and in direct competition with monetary policy. The labor market continues to be strong, as is wage growth. The stock market’s performance continues to support the economy. Given these realities, why should US rates plummet, which is what it would take to create an investing horizon that would be supportive of “total return” fixed income products.

05.01.24
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Another Challenging Month for US Fixed Income

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

S&P Dow Jones is out with its monthly “Dash Board” on a variety of benchmarks, both domestic and foreign. April proved challenging for both US equities and bonds. With regard to stocks, the S&P 500 was down -4.1% bringing the YTD performance to +6.04%. It was a tougher environment for both mid cap (-6.0%) and small cap (-5.6%). Small caps (S&P 600) continue to be pressured and the index is now down -3.3% YTD. As US interest rates continue on a course higher, US equities will continue to be challenged.

The higher US rates are also continuing to pressure US fixed income. The Aggregate Index produced a -1.8% April, and the index is now down -2.4% since the start of 2024 despite the rather robust YTM of 5.3%. As we’ve discussed on many occasions, bonds are the only asset class with a known cash flow of a terminal value and contractual coupon payments. As a result, bonds should be used for the certainty of those cash flows and specifically to defease pension liabilities. As a reminder, pension liabilities are bond-like in nature and they will move with changes in interest rates. Don’t use bonds as a total return strategy, as they will not perform in a rising rate environment. Sure, the nearly 40-year decline in rates made bonds and their historical performance look wonderful, but that secular trend is over.

Use the fixed income allocation to match asset cash flows of interest and principal to the liability cash flows of benefits and expenses. As a result, that portion of the total assets portfolio will have mitigated interest rate risk, while SECURING the promised benefits. Having ample liquidity is essential. Using bonds to defease pension liabilities ensures that the necessary liquidity will be available as needed. The current US interest rate environment may be pressuring total return-seeking fixed income managers, but it is proving cash flow matching programs with a very healthy YTM that dramatically reduces the cost of those future value payments. Don’t waste this golden opportunity.

04.30.24
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Healthier Than Ever? Nah!

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

P&I produced an article yesterday titled, “Corporate Pension Funds Are Fully Funded, Healthier Than Ever. Now What?” According to Milliman, corporate pension plans are averaging roughly a funded ratio of 106%. This represents a healthy funded status, but it is by no means the healthiest ever. One may recall that corporate plans were funded in excess of 120% as recently as 2000. In what might be more shocking news, public pension plans were too when using a market discount rate (ASC 715 discount rate). Today, those public pension plans have a funded status of roughly 80% according to Milliman’s latest public fund report.

The question, “Now what”? is absolutely the right question to be asking. Many corporate plans have already begun de-risking, as the average exposure to fixed income is >45% according to P&I’s asset allocation survey through November 2023. Unfortunately, public pension systems still sit with only about 18% exposure to US fixed income, preferring a “let it ride” mentality as equities and alternatives account for more than 75% of the average plan’s asset allocation. Is this the right move? No. The move into alternatives has dried up liquidity, increased fees, and reduced transparency. Furthermore, just because a public plan believes that its sponsor is perpetual, does that make the system sustainable? You may want to be reminded about Jacksonville Police and Fire. There are other examples, too.

Whether the pension plan is corporate, multiemployer, or public, the asset allocation should reflect the funded status. There is no reason that a 60% funded plan should have the same asset allocation as one that is 90% or better funded. All plans should have both liquidity and growth buckets. The liquidity bucket will be a bond allocation (investment grade corporates in our case) that matches asset cash flows to liability cash flows of benefits and expenses. That bucket will provide all of the necessary liquidity as far into the future as the pension system can afford. The remaining assets will be focused on outperforming future liability growth. These assets will be non-bonds that now have the benefit of an extended investing horizon to grow unencumbered. Forcing liquidity in environments in which natural liquidity has been compromised only serves to exacerbate the downward spiral.

Pension America has the opportunity to stabilize the funded status and contribution expenses. They also have the chance to SECURE a portion of the promises. How comforting! We saw this movie a little more than 20 years ago. Are we going to treat this opportunity as a Ground Hog Day event and do nothing or are we going to be thoughtful in taking appropriate measures to reduce risk before the markets bludgeon the funded status? The time to act is now. Not after the fact.

04.18.24
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What’s the Motivation?

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

There appears in the WSJ today an article stating that pension plans were pulling “hundreds of billions from stocks”. According to a Goldman analyst, “pensions will unload $325 billion in stocks this year, up from $191 billion in 2023″. We are told that proceeds from these sales will flow to both bonds and alternatives. First question: What is this estimate based on? Are average allocations now above policy normal levels necessitating a rebalancing? Are bonds more attractive given recent movements in yields?

Yes, equities have continued to rally through 2024’s first quarter, and the S&P 500 established new highs before recently pulling back. Valuations seem stretched, but the same argument could have been made at the end of 2023. Furthermore, US interest rates were higher heading into 2023’s fourth quarter. If bond yields were an attractive alternative to owning equities, that would have seemed the time to rotate out of equities.

The combination of higher interest rates and equity valuations have helped Corporate America’s pensions achieve a higher funded status, and according to Milliman, the largest plans are now more than 105% funded. It makes sense that the sponsors of these plans would be rotating from equities into bonds to secure that funded status and the benefit promises. Hopefully, they have chosen to use a cash flow matching (CFM) strategy to accomplish the objective. Not surprisingly, public pension plans are taking a different approach. Instead of securing the benefits and stabilizing the plan’s funded status and contribution expenses by rotating into bonds, they are migrating both equities and bonds into more alternatives, which have been the recipients of a major asset rotation during the last 1-2 decades, as the focus there remains one of return. Is this wise?

I don’t know how much of that estimated $325 billion is being pulled from corporate versus public plans, but I would suggest that much of the alternative environment has already been overwhelmed by asset flows. I’ve witnessed this phenomenon many times in my more than 40 years in the business. We, as an industry, have the tendency to arbitrage away our own insights by capturing more assets than an asset class can naturally absorb. Furthermore, the migration of assets to alternatives impacts the liquidity available for plans to meet ongoing benefits and expenses. Should a market correction occur, and they often do, liquidity becomes hard to find. Forced sales in order to meet cash flow needs only serve to exacerbate price declines.

Pension plans should remember that they only exist to meet a promise that has been made to the participant. The objective should be to SECURE those promises at a reasonable cost and with prudent risk. It is not a return game. Asset allocation decisions should absolutely be driven by the plan’s funded status and ability to contribute. They shouldn’t be driven by the ROA. Remember that alternative investments are being made in the same investing environment as public equities and bonds. If market conditions aren’t supportive of the latter investments, why does it make sense to invest in alternatives? Is it the lack of transparency? Or the fact that the evaluation period is now 10 or more years? It surely isn’t because of the fees being paid to the managers of “alternative” products are so attractive.

Don’t continue to ride the asset allocation rollercoaster that only ensures volatility, not success! The 1990’s were a great decade that was followed by the ’00s, in which the S&P 500 produced a roughly 2% annualized return. The ’10s were terrific, but mainly because stocks were rebounding from the horrors of the previous decade. I don’t know what the 2020s will provide, but rarely do we have back-to-back above average performing decades. Yes, the ’90s followed a strong ’80s, but that was primarily fueled by rapidly declining interest rates. We don’t have that scenario at this time. Why assume the risk?

04.08.24
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ARPA Update as of April 5, 2024

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

Welcome to ECLIPSE DAY. Good luck found me in Dallas today for the TexPERS conference, as it is in the path of totality (complete darkness). Bad luck has it heavily overcast today following a Sunday that had beautiful blue skies. Oh, well. Perhaps we’ll get lucky.

APRA’s implementation by the PBGC has slowed, and we don’t have earthquakes (NJ residents are still shaking their heads), eclipses, or any other natural event to blame. That is not to say that nothing has been done, as there was one new application received during the week. Printing Local 72 Industry Pension Plan, a Priority Group 5 member, submitted its revised application seeking $37 million in SFA for the 787 plan participants. Beyond that, I suspect that they are busy reviewing the 19 applications that have been submitted that are currently waiting on approval. Only 5 of those applications are the initial version.

As we’ve discussed in previous updates, census data used to determine SFA grant payments has had to be checked and rechecked following the announcement that Central States received more SFA grant $ than they were eligible to receive since some of the participants were no longer alive. That revelation and the corrective measures taken to ensure that SFA monies are only being allocated for eligible participants has really slowed an already cumbersome review. Despite some of these impediments, it is great that 72 plans have gotten the SFA awards totaling nearly $54 billion.

We might not have great visibility as it pertains to the eclipse, but with US interest rates tending higher, inflation remaining more “sticky” than hoped, and a Fed that may just not cut in 2024, visibility is clearer that cash flow matching the SFA is the way to secure the benefits and expenses well into the future. As a reminder, as rates rise, the cost to defease those promised benefits falls. Higher rates aren’t only good for savers. They are particularly good for SFA recipients and all plan sponsors of DB plans.

As an example of how that math works, when I entered this industry on October 13, 1981, the 10-year Treasury was yielding 14.9%. It would have only cost you $17.82 to defease a $1,000 30-year liability. On August 4, 2020, when the 10-year Treasury yield dipped to 0.52%, it would have cost you an extraordinary $860.40 to defease the same $1,000 30-year liability. As of April 5, 2024, the 10-year Treasury is yielding 4.41% and the cost to defease that 30-year liability is much more manageable at $301.00. You should be cheering for a higher for longer scenario.

03.28.24
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The Importance of Liquidity

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

I recently came across an article written by a friend of mine in the industry. Jack Boyce, former Head of Distribution for Insight, penned a terrific article for Treasury and Risk in July 2020. The title of Jack’s article was “We Need to Talk About the Armadillo in the Room”. It isn’t just a funny title, but an incredible simile for the two primary stages of a pension plan, notably the accumulation and decumulation stages of pension cash flows. The move from a positive cash flow environment to a negative cash flow environment creates a hump that is reminiscent of the shape of an armadillo.

I stumbled on an armadillo at TexPERS last summer and truthfully didn’t think at that time that I was looking at a pension funding cycle, but I’ll never look at an armadillo again without thinking about Jack’s comparison. But the most important aspect of Jack’s writing wasn’t that he correctly associated the funding cycle with a less than cuddly animal, it was the fact that he highlighted a critically important need for pension plan sponsors of all types – liquidity! I’ve seen far too often the negative impact on pension plans and endowments and foundations when appropriate and necessary liquidity is not available to meet the promises, whether they be a monthly benefit, grant, or support of operations.

The last thing that you want to have happen when cash is needed is to be forced to raise liquidity when natural liquidity is absent from the market. There have been many times when even something as liquid as a Treasury note can’t be sold. Just harken back to 2008, if you want a prime example of not being able to transact in even the most liquid of instruments. Bid/ask spreads all of a sudden resemble the Grand Canyon. As we, at Ryan ALM have been saying, sponsors of these funds should bring certainty to a process that has become anything but certain. Jack correctly points out that “a typical LDI approach focuses on making sure the market value of a plan’s assets and the present value of its liabilities move in lockstep.” However, too often “these calculations fail to factor in the timing of cash flows.” We couldn’t agree more. Where is the certainty?

His recommendation mirrors ours, in that cash flow matching should be a cornerstone of any LDI program. Using the cash flow of interest and principal from investment grade bonds to carefully match (defease) the liability cash flows secures the necessary liquidity chronologically for as long as the allocation is sustained. By creating a liquidity bucket, one buys time for the remaining assets in the corpus to now grow unencumbered. As we all know, time is an extremely important attribute when investing. I wouldn’t feel comfortable counting on a certain return over a day, week, month, year, or even 5 years. But give me 10-years or more and I’m fairly confident that the expected return profile will be achieved.

Jack wrote, “pension plan sponsors need thoughtful solutions”. We couldn’t agree more and have been bringing ideas such as this to the marketplace for decades. Like Jack, “we believe a CDI approach can simultaneously improve a plan’s overall efficiency and the certainty of reaching its long-term outcome.” Certainty is safety! We should all be striving for this attribute.

03.25.24
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ARPA Update as of March 22, 2024

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

“March Madness” is upon us. How’s your bracket doing? I still have my champion in the running, but not much more than that.

The past week was very quiet with regard to the ARPA legislation and activity associated with its implementation. We did have one fund submit an application for Special Financial Assistance (SFA). United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Plan, a Priority Group 6 member, submitted a revised application on March 16th. This fund is seeking SFA in the amount of $638.3 million for the fund’s 29,233 members. The PBGC will now have until July 14, 2024 to act on the application.

Besides the filing by the UFCW, there was little to show last week, as there were no applications approved, denied, or withdrawn. Furthermore, unlike the prior week, there were no additions to the waitlist which continues to have 113 funds listed of which 27 have been invited to submit an application. To-date, 71 funds have received SFA in the amount of $53.6 billion. These proceeds include the grant, interest, and any FA loan repayments.

Like the picking of the NCAA tournament bracket, for which there are no perfect submissions remaining, the capital markets are highly uncertain. Yes, the US equity market has enjoyed a robust 5-6 months period, but how predictive is that for the next six months or longer? Those yet to receive the SFA should seriously consider an investment strategy that takes the uncertainty of the markets out of the equation. I am specifically referring to the use of investment grade bonds to defease the promised benefit payments as far into the future that the SFA allocation will cover. Once the matching of asset cash flows to the plan’s liability cash flows is done, that relationship is locked in no matter what transpires in the capital markets. Any risk taken by recipients of these assets should be done in the legacy portfolio where a longer investing horizon has been created. Fortunately, US interest rates remain elevated significantly from when the ARPA program began in 2021. The timing couldn’t have been better.