We’ve all become intimately familiar with Wall Street’s well-publicized “Great Rotation,” which predicts that investors will rotate out of bonds and into equities because of low bond yields. But such a reversal won’t necessarily hold true for large institutions that actually might find it beneficial to increase their fixed-income allocations.
There is an institutional narrative here that centers on defined benefit pension plans. The focus on pension plan deficits has become increasingly common in the past few years. No matter what has unfolded in the equity markets, bond yields have been moving lower. With the liability calculated using the yield of a long-dated corporate bond, lower yields have increased the deficit and thus the headache for plan sponsors and trustees alike.
At this moment, however, pension plans are in a rather fortunate position. Their funding ratios should have improved because of the doubleheader of rising equity markets and rising bond yields. It’s an opportune moment for fiduciaries to consider locking in gains by switching into long-duration fixed-income assets. For many pension plans, a further allocation into long bonds could be an attractive way to derisk by reducing the mismatch between their assets and liabilities.
For most of these plans, funding ratios — the amount of assets held by plans relative to the liabilities they have to pay out — have improved since the beginning of 2014 and are now in excess of 90 percent, compared with nearly 70 percent just 12 months ago. The assumption in the popular press has been that all the demand is rotating into equities. But the corporate bond market is much more institutional than retail, and the bias for institutional investors tends to be much more in the other direction. The asset allocation to bonds in defined benefit plans in the U.S. is roughly 45 percent at present. That’s gone up about 5 to 10 percentage points during the past five years. And with the increase in funding ratios, there could be a significant amount of demand, especially for the longer end of the market.
To fully understand this dynamic, it’s critical to examine the hedge ratio of U.S. pension plans. Most pension plans manage their fixed-income assets against the Barclays aggregate bond index, or the Agg, which has a five-year duration, although the liabilities of those plans tend to be about 14 years. Here’s what many observers fail to detect: Most pension plans have a significant interest rate mismatch between their assets and liabilities, so there’s actually a lower risk from a funding perspective for a pension plan to have a liability of 14 years. But that’s the key. Defined benefit pension plans are sensitive not to total return but to relative return to their liabilities.
This mismatch is critical because even though the U.S. plans have similar allocations to fixed income, when compared with U.K. plans their interest rate exposure is very different. The Agg-based mandate that people have historically favored in the U.S. is far from the appropriate duration for pension plans; it’s not even necessary to increase their allocations to fixed income. Half the battle is just changing fixed-income allocation to a more appropriate duration.
The biggest risk for a defined benefit plan in terms of the funding ratio isn’t the equity allocation or the contribution but the discount rate. Pension plans are discounted by a long double-A-rated bond yield, rendering that by far the most significant risk. And they’re much more susceptible to moves in long bond yields than they are to moves in the equity market. For example, if the plans have liabilities of 14 years, and long bond yields go up 100 basis points, that means that their liabilities will drop by roughly 14 percent.
If interest rates were to rally 1 or 2 percentage points, there would be a massive movement by plans into underfunded status again. It can’t be stressed enough that the objective of a defined benefit plan is not total return but maximizing the assets relative to the liabilities. The goal is to pay off those obligations. In the U.S. there’s a significant mismatch between pension plans’ assets and their liabilities.
There was positive impact from rising equity markets in 2013. This tends to attract people’s attention. But the most important element is actually the rising yields at the long end, which should decrease the liability and improve funding ratios.
Ideally, a completely funded pension plan would have all of its assets in bonds because the assets and liabilities would be matched. The assets and liabilities would move in parallel with changes in interest rates.
The larger, more sophisticated pension plans do seem to be aware of these scenarios, as there is legislation pushing them in that direction. They are still vulnerable to the influences of equity movements, however, making it hard for them at times to move away from that total-return focus.
It’s important to note that as pension fiduciaries and sponsors become more comfortable with the idea of increasing their hedge ratio, it does not mean that active management will come to an abrupt end. The risk inherent in a liability-driven investing solution is lower than for a traditional asset allocation, but the bulk of the risk reduction is the result of interest rate hedging, not a dramatic change in other degrees of freedom. If anything, there are more opportunities now for adding value in the long end of the market.
Low funding levels have been an obstacle to implementing some of these strategies since the financial crisis of 2008. But that could be changing. It’s true that plan managers are likely to move to increase allocations to their fixed-income portfolios as they grapple with regulatory changes and seek ways to reduce funding level volatility. Bonds are the right vehicle for matching movement in liabilities. Being able to pay out those liabilities as they come due is crucial for a pension plan.
It goes without saying that investors are likely to take advantage of this moment and reevaluate their bond portfolios, as has already happened in the U.K. It only makes sense that U.S. plans will now increase their hedge ratios as their funding levels increase.
Andrew Chorlton and Neil Sutherland are portfolio managers for fixed-income value for Schroders Investment Management North America in New York.
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