After years of near-zero policy rates, institutional investors are still waiting for a return to a normalized level of long-term interest rates. Whereas many pensions have embraced liability-driven investing in recent years, asset-liability mismatches remain. A rise in long-term bond yields would allow pension investors to close duration gaps at higher levels of funding.
But what if it turns out that we’re in an environment of lower yield and lower returns for longer than we expected? What if the slow rates of real and nominal growth we have experienced since the 2008–’09 financial crisis are reflective of long-term secular trends?
Let’s consider three underlying reasons why we may be facing lower long-term growth across asset classes.
We believe lower productivity could limit GDP growth and keep rates low. The most reliable long-term driver of GDP growth is productivity growth. Since World War II, productivity has been slowing across the developed world. There are few signs today that a new wave of expansion is imminent. The source of productivity and the factors that influence it are complex questions for economists to debate.
Demographic trends could also constrain rates. An aging population and the subsequent dwindling in the labor force put a speed limit on nominal growth numbers. That implies lower nominal and real interest rates ahead.
Structural adjustments in Europe, China and Japan will mean slower global growth. U.S. long bond yields are clearly impacted by developments in the rest of the world. Although the European Central Bank has implemented quantitative easing to buy time for Europe to sort out its economic problems, it is hard to make the case for a sustained renaissance in growth on the Continent. In fact, Europe still faces the prospect of several more years of adjustment to low growth as high unemployment and stagnant wages and then before competitiveness in these countries can be restored. Meanwhile, we believe that China is in the midst of a heavily managed but inexorable decline in structural growth rates to a likely range of 5 to 6 percent on a consistent basis. Japan’s aggressive program of quantitative easing is also helping to depress bond yields globally. Ongoing declines in that country’s labor force suggest that low rates of growth, accompanied by low bond yields, will persist for the foreseeable future.
A lower baseline for risk-free rates in turn implies lower long-term capital markets returns. Low asset return expectations come at a challenging time for institutional investors. Many pension plans are facing recent or upcoming hits to funded status as they incorporate updated mortality assumptions. As a result, many corporate plans have fallen down — rather than up — their glide paths and are debating whether to derisk at even lower yields or to rerisk and await higher rates. State and local government budgets are increasingly strained by rising pension contributions. In a low-return world, public pension plans will either need to reduce their return assumptions, requiring further contribution increases, or reconsider their investment policy.
There are currently a number of incentives for corporate plans to derisk. As more sponsors freeze or close their plans, the number of companies eager to increase the duration of their pension portfolios increases. Furthermore, the need to derisk at higher interest rates remains widespread, given the desire to mitigate the balance-sheet and earnings volatility impact of pension-funding-status volatility. Therefore, in our view, there is pent-up demand for long corporate bonds from plan sponsors at high yields. We expect that derisking flows will bolster demand for fixed-income assets, as will insurance companies and non-U.S. investors. As a result, total estimated demand for corporate bonds is likely to far exceed expected supply.
According to our analysis, the total supply of corporate bonds is estimated to grow by $500 billion by 2019, whereas total estimated demand in 2019 could grow by $1.49 trillion. The supply-demand imbalance of corporate bonds is another factor that could possibly limit the rise in long-term bond yields in coming years.
In an investment climate in which risk-free rates — and therefore all capital market returns — are maintained below levels that have previously been considered normal, pension funds have a choice. They can either increase contributions or fundamentally reexamine their investment strategy to see whether there are other levers they can pull to generate the returns that they need to meet future obligations.
Tony Gould is the global head of pension solutions and advisory at J.P. Morgan Asset Management in New York.
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