Rates Rise; Then What?

From aiCIO Magazine's February Issue: What happens to the assets and liabilities of various capital pools when--not if--rates eventually rise?

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Picture a world in which the nominal yield on 10-year US Treasuries is hovering around 5%. Sounds like a strange place, right? It shouldn’t. Since the abandonment of the gold-pegged dollar in 1971, the average yield on 10-year government notes has been just north of seven percent and A-grade corporate bonds have, of course, paid more than that.

So imagine that interest rates have mean-reverted to levels more consistent with historical averages. What should pension managers consider at that point and, more importantly, what should they have considered while rates were lower?

This year started with the Fed’s announcement that there will be transparency over any planned interest rate hikes. In late January, Ben Bernanke said that rates would not rise until the end of 2014. For cautious investors, however, it is worth bearing in mind that the Fed is not the final arbiter of where real rates trend—the market is. And, while the market is currently signaling that higher rates are still a ways off, there is something inarguably apt about what that other Ben said (the one who concerned himself with US monetary affairs). Ben Franklin’s maxim was that by failing to prepare, you are preparing to fail.

Rising rates will be generally welcomed by plans because liabilities become revalued downward with a higher discount rate. David Kelly, Principal at Mercer Investment Consulting, says “Most pensions see funded status improve 8-10% with a 1% rise in interest rates.” What makes upwardly mobile rates a true boon is that despite the increasing number of plans moving toward liability hedging strategies, the majority of plans maintain a significant duration mismatch between assets (two to five years for total assets) and liabilities (10-15 years). This makes liabilities far more sensitive to rate changes than assets.

When rates become frothier again and plans have options that have been out of sight since funding status levels went down the tubes in the late 2000s, what issues will sponsors face? Obviously, they will be in a better position to pay out participants via lump sums or outsource to third-party managers at lower costs. The majority of plans, however, will continue operations as usual—but will want to smooth out earnings volatility and reduce their interest rate risk.

The trouble those plans will have when rates rise is that there will likely be a shortage of fixed-income assets which fit sponsors’ criteria for quality and the ability to match liabilities. As funding statuses improve, a significant number of plans will want to cement their gains by buying products with durations that cover their obligations. As a result, Andy Hunt, Lead LDI Strategist with Blackrock, says “technicals due to supply and demand may overtake fundamentals in terms of the pricing of long corporate bonds.” Hunt predicts that pension plan demand for long corporate bonds is going to rise substantially over the next decade, reaching an estimated $1.2–$1.6 trillion by 2020, compared with the currently held amount of roughly $500 billion. The entire market of long investment grade corporate bonds is now only about $850 billion, much of which Hunt points out, “is held by life insurance companies who are unwilling sellers.”

Here is a possible result of a buy-up in corporates: those plans that do not acquire longer assets while they are available could potentially face spread compression that could increase the cost of their liabilities even if rates were rising. “The solution for those who are concerned about this,” Hunt says, “is to de-risk before the rush to those assets really starts.” He says another option is “to buy long corporate bonds and if they are worried about the effects of rising rates on asset values, use treasury futures to manage their treasury duration risk.”

Scott Minerd, CIO of Guggenheim Partners, adds that, “The dearth of high quality assets will be even more pronounced with the downgrade of global sovereigns.” He believes the solution lies in maintaining a core portfolio that will benefit from rate spikes. For Minerd, there is value in “floating rate asset-backed securities (ABS) and, specifically, collateralized loan obligations that have negative duration, causing them to rise in price when rates increase.”

Minerd suggests holding these “as barbells on the other side of 30-year AA zero coupon bonds which yield close to 6% annually and will outperform 30-year coupon bonds when short term rates begin to rise and the yield curve flattens.” He says portfolio duration of 10 years is theoretically possible with a variation on this mix and “the real payoff will come when rates finally rise and people step into the long end of the curve to reduce their current short duration positions.”

But as Minerd readily points out, ABS is still a four-letter word to many. For those seeking another approach to securing long-duration fixed-income assets before rates climb higher and pension demand heats up, a move toward a more conventional LDI strategy or a variation with a synthetic overlay may be prescient. This runs counter to the commonly held view of many managers that a low rate environment is the wrong time in which to hedge their liabilities with costlier bonds, but the case can be made that the cost of waiting is significant as well.

Rene Martel, Executive VP with PIMCO, believes “If it takes a few years for rates to rise, or if they do so in a non-parallel fashion across the curve, the opportunity cost of hiding in short durations could offset the presumed benefits of waiting for the opportune time to act.” Martel thinks in certain cases it is worthwhile for plan managers who believe rates will rise to consider “buying long bonds in advance of rising rates and shortening the portfolio duration to the desired level by using interest rate swaps or other derivatives.” This way, “plan sponsors can acquire long-dated corporate bonds before demand increases, and they could gain a yield advantage in excess of one hundred basis points while keeping a neutral duration exposure relative to traditional intermediate duration bond indices.” 

This strategy can also be combined with a pre-commitment to a gradual extension of duration as rates rise by selling interest rate options.  Martel says, “Plan sponsors can collect an additional one hundred basis points in annual income from the sale of options until rates have come up meaningfully.” According to Martel this strategy would be most suitable for plan managers who ultimately want to extend asset duration, but are not inclined to do so while rates are zero bound.

Many plan sponsors currently increase or patch up their duration with derivatives—but few are using them to shorten it. In both cases, it is important to understand and make contingencies for margin requirements. Rising interest rates will naturally have an adverse effect for plans that have margin accounts backing long derivatives positions used to extend duration. But, in the case of the strategy described above, because the plan is on the pay fixed side of a swap, the concern is that rates will languish or fall again, meaning swap values will drop contemporaneously. In that case, Martel says, “the underlying bond portfolio will likely be strengthening, thereby providing additional collateral to meet margin requirements on the swap position.” 

No matter what steps a plan takes toward ensuring they have room to maneuver in a higher interest-rate environment, when rates have risen, they could easily fall again—so implementation is critical. Vijendra Nambiar, Product Manager with PIMCO’s LDI team and a colleague of Martel’s, says, “We have seen that the decision-making process with some of plans can be a lengthy one, so plan sponsors may want to take steps well before they plan to act to educate and prepare their boards.” Mark Ruloff, Director of Asset Allocation with Towers Watson, agrees, saying “Operational issues are key and plans should have their goals written in the investment policy statement in advance of any necessary changes.”

For pension plans with any degree of duration mismatch, rising rates will present a positive arbitrage opportunity. Carefully constructed strategies focused on the fixed-income portion of a portfolio will give managers tools to lock in funding status improvements when some of the liability weight is lifted. Thus, the decisions made before rates rise are critical. In these paranormal times, and indeed when rates are up again, plan managers should heed the words of Isaac Asimov, the science fiction legend, who said that “No sensible decision can be made any longer without taking into account not only the world as it is, but the world as it will be.” —Aran Darling