As inflation continues to soar, rates increase and geopolitical volatility spikes, defined benefit plan sponsors are tasked with increasingly complex decision-making. In this paper, we outline the five biggest challenges currently facing defined benefit plans and provide thoughts on how to manage them.
1. Challenge: Managing persistent inflation?
US CPI hit a record high in October of 2021 with headline inflation reaching 6.2% y/y and core inflation, which excludes food and energy, coming in a 4.6% with just about everything from medical to housing costs moving higher. Additionally, the US household savings rate has fallen back to more normal levels. The cost of goods and services are rising and, in response, real disposable income is falling. Now, upon retirement of the word “transitory”, US CPI is 7% y/y and The Fed has finally begun to take action. The minutes of the December Federal Open Market Committee (FOMC) meeting were the beginnings of a more in-depth discussion on balance sheet normalization, which taken together with their updated Fed funds rate forecasts, offers clues as to how the Fed might approach policy tightening this year in order to combat inflation. As a reminder, the median projection of the December Fed “Dots” reflected three rate hikes this year and three next year. The minutes emphasized the Fed funds rate (FFR) as the primary monetary policy tool, as well as the desire to get off of the zero lower bound and begin balance sheet normalization relatively quickly after the initiation of the rate hiking cycle. The FOMC also talked about the key differences between quantitative tightening (QT) this time and QT in the previous (and only other) time the Fed reduced the size of its balance sheet, which was from 2017-2019. First is the macro outlook with stronger growth, higher inflation and a tighter labor market today; second is the significantly larger size of the Fed’s balance sheet, which at almost $9 trillion is twice its size versus in 2017. There is no consensus on what constitutes the optimal size of a central bank’s balance sheet, and the Fed itself acknowledged that there’s more uncertainty about the macroeconomic effects of changes in the balance sheet versus changes in the policy rate. Nonetheless there’s certainly a desire from the FOMC to shrink its balance sheet given high inflation and a labor market likely approaching maximum employment with the unemployment rate now under 4%.
This should naturally have an impact on the front end of the curve with now five rates hikes priced into the market over the next year. But, maybe that won’t be true! One final comment in the minutes suggested relying more on balance sheet reduction and less on the policy rate to limit yield curve flattening, which as you can see in the chart above has happened quite dramatically this past year. Since last March, the 2s10s curve has flattened from 160 basis points (bps) to 62 today, while the 5s30s curve has gone from 160 to 44 bps. Inversion of the 2s10s curve is considered a leading indicator of recession. We have been calling for flatter curves in 2022, but as this trend continues, watch for signs from the Fed that may try to steepen the yield curve.
2. Challenge: Volatility in equity markets?
The CBOE VIX level reached as high as 38.9 in late January surpassing a 2021 high of 39.3 reached in early December of last year. Equity markets have been dealing with elevated levels of volatility lately that have ushered in negative equity market performance to begin the year. The S&P 500’s -5.17% return is the worst start for US Large Caps since the -8.43% return in 2009 which was roiled by the GFC. There are a number drivers for today’s volatility, which include a persistent pandemic, higher inflation levels and a hawkish Fed, which is in stark contrast to the accommodative monetary policy that has kept volatility artificially low for a while. In fact, the cumulative total return of the S&P500 Index over the past three years hits 100%! However, volatility today, unlike that back in 2009, isn’t a result of a systemic issue, but instead due to a valuation adjustment and the concern of the Fed’s misguidance. The global macro backdrop is actually relatively healthy with higher levels of GDP Growth, low levels of unemployment and high historical levels of household wealth. It’s for these reasons, we believe that equities could still perform well this year. In fact, there is no strong correlation to how market’s perform to start the year and how they ultimately end the year. Increased implied equity volatility is only part of the story regarding choppy markets as credit spreads have widened over the past few months, with investment grade +10 bps and high yield +71 bps since December 31, 2021. While credits also experiencing heighted levels of volatility, January’s move represents a lower price point with slightly more attractive yields, given what were historically tight spreads in 2021. Heightened levels of volatility can hurt funded ratios, whereby growth assets and credit spreads tend to be negatively correlated to rising volatility. For open and accruing plans, the composition of these assets is likely one of the most important considerations for plans in 2022.
3. Challenge: Positioning for further bear flattening
Bear flattening muscled in following the record-high US CPI print in October, as markets pulled forward their expectations for Fed tightening and short-end Treasury rates rose. By November 30, the Fed announced that the high inflation rate would no longer be considered “transitory”. We believe that inflation will be here longer than expected, putting upward pressure on short-term rates.
Meanwhile, 20- and 30-year bonds continue to see a strong bid due to higher funding ratios from defined benefit plans and from low rates that are driving plans into longer-duration assets. If equity markets continue to perform strongly, funding ratios could continue to improve, leading plans to further allocate to long-dated fixed income. Plus, the rise in plans seeking pension risk transfers and the strategies of Taft Hartley plans—where plans are migrating into fixed income—lead to increased demand for long-end bonds.
To manage the flattening, we have seen increasing conversations around a barbell strategy – buying shorter and longer bonds (strips) at either end of the curve, while staying out of belly. This allows for positive payouts in a wide range of scenarios, as there is still uncertainty as to how the yield curve my shift and how quickly rate hikes will occur.
Risks to the Bear Flattening Outlook
The Fed has indicated that a more aggressive inflation response is forthcoming. If these measures are adequate to keep inflation at bay, flattening is more likely. However, risks to the bear flattening outlook include central bank behavior that is perceived as behind the curve on inflation, which could lead to steepening. The flattening trend could also vary by region. Those with rates already rising could see bear flattening, while regions such as the eurozone—where hikes are a ways off—could experience steepening. We also note that terminal rates remain in focus, as market-implied terminal rates could tick higher and lead to more of a parallel shift higher, versus a bear flattener.
4. Challenge: Combating tight investment-grade bond spreads
Investment grade (IG) corporate spreads have reached historic tights, casting doubt on whether high-quality corporates still make sense for defined benefit plans. In our view, the strong fundamental backdrop and potential for hedging against equity volatility continue to make the case for IG corporates. However, the allocation must be made thoughtfully given inherent risks to the carry trade because of ultra-low spreads.
The fundamental backdrop for IG credit remains strong. In 2020, fallen angels reached more than $230 billion, but in 2021, fallen angels only totaled $9.5 billion, and $45 billion worth of bonds migrated back from high yield to investment grade. The low cost of capital and the ongoing fiscal spend has led to rising operating margins, which also improved leverage ratios. This fundamental backdrop will continue to enable a benign default environment. Indeed, default rates and distress ratios are approaching longer-term, pre-COVID lows.
The key, then, is how investors can take advantage of the strong fundamental IG landscape despite record-tight spreads. One mechanism is to extend the duration of the fixed-income allocation, increasing the targeted hedge of liabilities while still having less capital allocated to fixed income. Another tool is to maintain allocations at the high end of the corporate quality spectrum, as spread compression has led to investors receiving less of a yield pick-up from going down in quality. Furthermore, investors may consider securitized debt, where spreads are still compelling relative to Treasury bonds and corporate bonds. Ongoing strength in the residential housing market points to strong fundamentals for agency and non-agency MBS, despite increased convexity. Another important investor consideration is the impact of spread widening on the asset versus liability sides of their cash flow streams and the determination of whether lower liabilities (from higher discount rates) may improve funding status, rather than deteriorate it.
5. Challenge: De-risking thoughtfully and efficiently
As we discuss in De-Risking Effectively Using Fixed-Income Building Blocks, investors planning to de-risk should aim to avoid pitfalls that could prevent them from reducing funded status volatility. This is especially important given today’s rate uncertainty, as it is more difficult to hedge the rate movements that could change a plan’s expected liability stream.
We have discovered that for many plans, the standard LDI benchmark (the Bloomberg Barclays Long Government-Credit Index) has greater sensitivity to very long-dated bonds—a difference that could be problematic if rates rise more in the long end than in the short end. In this case, the Index (the asset side) could be even more negatively impacted than the liability side. Credit exposure is also different for some standard long-dated indices versus the payouts on the liability side.
At State Street Global Advisors, our Fixed Income Building Blocks provide customized solutions that can more precisely match assets with liability characteristics, standing in the way of duration, spread, and credit mismatches. For example, if curve exposure is mismatched, we may fill out curve exposure using US Treasury instruments by targeting gaps in rate exposure from the liability stream. We can accomplish this by allocating to various maturity Treasury funds. Given the emphasis on long-dated liabilities, we may also make an allocation to the 20+ Year U.S. Treasury STRIPS Index Strategy, which precisely targets those longest rates. Benefits of scale can also be used to help clients control transaction costs.
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