Growing bond spreads put defined benefit plans at risk
A lackluster 2015 and tumultuous start to 2016 for the stock market has the defined benefit (DB) world on high alert. Plan sponsors and advisers sit transfixed like overworked air traffic controllers at their monitors, charting allocation vectors amid a screen filled with flashing warning lights.
But with all this focus on avoiding equity catastrophes, a much more subtle threat to DB funding positions has flown unnoticed beneath the radar—quality spread risk within fixed income holdings.
The concept of liability driven investing (LDI) has become part of the DB zeitgeist, so the idea of hedging pension liabilities with duration matching bond investments is familiar to most people managing plans.
What occasionally gets overlooked, however, is that pension liabilities behave like high quality bonds.
Pension payments are made in regular intervals like coupons, and the probability of default on those payments is very low thanks to minimum funding rules and Pension Benefit Guaranty Corporation (PBGC) insurance. So they behave like a debt from a reputable company as opposed to a loan repayment plan from your brother-in-law.
One objection to hedging pension risk with high quality bonds, however, is that current yields are quite low. Since most plans are still underfunded on a market value basis, the search for extra yield to close this gap led many to consider lower quality (“higher yield,” euphemistically) fixed income vehicles for their portfolios.
Theoretically, higher yielding bonds that match the duration of pension liabilities can reduce volatility risk with higher nominal yields. But this only holds when movement of the underlying quality yield curves are similar. This absolutely hasn’t been the case the past twelve months.
Using a high quality (AA or higher) long corporate bond index1 as a proxy for the behavior of typical pension accounting liabilities, one sees that rates increased 78 basis points over the 12-month period from January 31, 2015 to January 31, 2016. An increase of this magnitude reduces liabilities for a typical DB plan by 7 percent to 12 percent.
Higher quality treasuries increased too, but not as dramatically. Long government bond index2 yields increased 44 basis points for the 12-month period. By subtraction, the resulting “spread” between high quality long corporate bonds and long government bonds increased 34 basis points (78 basis points minus 44 basis points). This suggests demand for safer fixed income investments increased throughout the year—a “flight to quality.”
By definition and double-negative logic, a “flight to quality” is also a “flight away from non-quality.” This is borne out by examining the movement of a high yield long bond index3, which increased 197 basis points over the period.
In other words, the spread between the high yield index and pension liabilities (represented by the long corporate AA and higher) increased 119 basis points (1.19 percent) over the 12-month period.
The widening spread between higher yielding fixed income and pension liabilities is clear. “Junkier” quality levels fared even worse.
Liabilities as an investment benchmark
Since the market value of bonds (and pension liabilities) moves inversely to interest rates, rising rates mean lower market values. Faster bond rate increases mean sharper losses to the market values of the underlying bonds.
Based on the simple example below for a typical plan, a portfolio invested in high yield bonds would have underperformed pension liabilities (represented by long corporate AA and higher) by more than 2 percent over the 12-month period. Conversely, increasing spreads meant that higher quality, lower yielding government bonds outperformed liabilities by about 3 percent over the same timeframe even though the gross returns were still negative.
"But with all this focus on avoiding equity catastrophes, a much more subtle threat to DB funding positions has flown unnoticed beneath the radar—quality spread risk within fixed income holdings."
So “high yield” doesn’t necessarily translate to “high returns” when measured against market value pension liabilities. Thanks to significant interest rate sensitivity from relatively long duration, sharp expansion or contraction of spreads can easily outweigh the difference in nominal yields. High yield tends to underperform pension liabilities when quality spreads widen significantly.
Additional spread turbulence may be ahead as the grudging disclosure of China’s economic slowdown works itself through world markets. It seems investment managers could have their hands full piloting their portfolios through risky equity headwinds.
Their collective decisions regarding risk exposure will determine whether or not the flight to quality continues through 2016. No one can say for sure which direction spreads will move this year—especially not a blogging actuary—but fiduciaries of DB plans would be wise to consider quality as well as duration when designing their LDI strategies.
A version of this blog originally ran on the Principal blog.
1Barclays US Aggregated Corporate – Long (AA or >)
2Barclays US Aggregated Government – Long
3Barclays US Aggregated Credit – Corporate High-Yield – Long (B)
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