The bond market is in focus. There were three quarter-point federal fund rate increases in 2017, with an expectation of roughly three more increases in 2018. Given the Fed’s actions, coupled with continued economic growth and the potential impact of the recently passed Tax Cuts and Jobs Act of 2017, we are recommending that corporate clients take a close look at the interest rate hedging strategy in their DB plans. The 30-year Treasury yield has already increased significantly since the beginning of the year and is comfortably above 3 percent. Since many corporate pension plan sponsors have dynamic strategies that drive allocations between their return-seeking portfolio and liability-hedging portfolio, we believe they should consider a similar approach for their target liability-hedging portfolio, if such a strategy does not already exist.
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Return needs versus hedging
Many DB plans remain underfunded and are relying heavily upon the equity markets and other return-generating strategies, such as real estate and private credit, to help close the gap. The ideal scenario encompasses strong equity returns coupled with rising interest rates that would lower the value of pension liabilities. We recommend that plan sponsors consider a strategy that enables the extension of asset duration and therefore the hedging effectiveness of the portfolio, while still allowing for the equity market to provide strong returns.
The hedge ratio is defined as the ratio of the change in assets divided by the change in liabilities for a 1 percentage point change in interest rates. A “hedge path” is a strategy to phase in a higher hedge ratio as a DB plan’s funded ratio and/or interest rates increase. As outlined in the exhibits on the next page, a hedging strategy that is implemented independently from the asset allocation strategy would establish an effective phase-in strategy to the target liability-hedging portfolio. This approach enables plan sponsors to remove interest rate risk from their DB plans as rates rise, while retaining the ability of the equity and other return-seeking investments to drive value.
Let’s use the 90 percent funded ratio level in the exhibits as an example. If the funded ratio moved from 90 percent to 95 percent while forward interest rates are 1 percentage point or more below the predefined “target” interest rate, the duration target of the liability-hedging portfolio would increase from 4.2 to 8.8 basis points. If interest rates were subsequently to move up 1%, causing the funded ratio to increase to 100 percent, the duration target of the liability-hedging portfolio would increase from 8.8 to 12.9 basis points.
Effectively the hedge path creates a phase-in approach to longer duration in the liability-hedging portfolio as the DB plan’s funded ratio and/or interest rates rise over time.
The implementation of duration extension driven by a rising interest rate environment can be accomplished by: 1) investing in longer-duration physical instruments, such as long corporate and government bonds; 2) introducing ultra-long-duration physical instruments, such as Treasury STRIPS; and/or 3) implementing a synthetic overlay consisting primarily of Treasury futures and/or interest rate swaps. All these strategies can be implemented without decreasing the plan’s exposure to return-seeking investments.
We believe it is important to understand the key risks of the chosen investment strategy and the rewards of taking those risks. We believe for most corporate DB plans, by far the two largest financial risks are equity market risk and interest rate risk. When determining which risks to take and which to avoid, it is important to determine whether the risk exposures being considered are viewed as rewarded or as unrewarded risk. Risks that are viewed as rewarded risks may be worth taking, while unrewarded risks are best avoided. Equity market risk, for example, is typically viewed as a rewarded risk, and thus may be worth taking for investors with an appropriate risk tolerance. However, we view interest rate risk today as asymmetric, with the likelihood of drastic interest rate changes skewed to the upside. This has implications for the risk-reward characteristics of interest rates and fixed income securities, and ultimately impacts pension plan portfolio positioning.
Developing a strategy that clearly separates the approach to managing different risks can be beneficial to the overall strategy. We believe the current market environment calls for a refocus on interest rate strategy to ensure that the key risks inherent in the chosen investment strategy are being properly measured and the magnitude of potential reward is understood.
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