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- Following a blockbuster first quarter that saw aggregate single-employer plan funded status increase by nearly 8%, aggregate funded status declined slightly in the second quarter of 2021 as strong equity market returns were offset by falling Treasury yields and tightening credit spreads.
- This quarter’s market movements (declining Treasury yields and tighter credit spreads) serve as a good reminder to ensure that tactical deviations from asset allocation, hedge ratio, or duration targets align with plan sponsor market outlook, risk tolerance, and time horizon.
- Given historically low credit spreads, active management in credit is key to both an effective credit spread hedge and alpha generation.
- Year-to-date pension risk transfer activity is slightly below prior years, but the mix of transactions is different, underscoring the unique nature of each particular client situation.
Figure 1 : Funded Status Drivers
Source: Bloomberg Index Services, Milliman, MSCI. The funded status and discount rate are for the Milliman 100 Pension Funding Index.
In contrast to the first quarter of 2021, when a combination of sharply rising discount rates and strong equity market returns propelled many plans’ funded status to the highest levels since the 2008 global financial crisis, the second quarter was more mixed. Although equity markets continued their bull run with the MSCI All Country World Index (Net) returning 7.4% for the quarter (and 12.3% year to date), discount rates fell 38 basis points2 (bp), retrenching more than half of the first quarter’s 66 bp increase and offsetting gains from equities for underhedged plans. Milliman estimates that the aggregate funded status of the 100 largest plans fell 1%, though each plan's unique asset allocation and hedging program may have resulted in somewhat different outcomes. The decline in discount rates was largely the result of falling Treasury yields: 10- and 30-year Treasury yields fell roughly 30 bp while the spread of the Bloomberg Barclays U.S. Long Credit Index (Long Credit) tightened 8 bp.
Staying Close to Targets Pays Off
Heading into the second quarter, Treasury yields appeared to be on a steep upward path, spurred by expectations of higher inflation, and credit spreads were at their lowest levels since the 2008 global financial crisis. In this environment, many plan sponsors may have considered being tactically short interest rate hedge ratio targets and/or credit spread hedge ratio targets. While certainly justifiable from a valuation perspective, these tactical decisions would have detracted from funded status as both Treasury yields and credit spreads declined. This experience underscores the importance of both making sure that the magnitudes of any tactical deviations from strategic targets are within risk tolerance levels and maintaining an appropriate time horizon for evaluating tactical decisions.
Figure 2: Net Corporate Issuance
Source: JP Morgan.
Hedging Interest Rate Risk Remains Sensible
Although we believe that long Treasury yields are more likely to rise than fall over the next 12-24 months, we recognize that the road to higher interest rates may be bumpy. The continuing but uneven economic recovery, expectations of higher-than-normal but transient inflation, and the Federal Reserve’s accelerated timetable for raising the Fed Funds rate may be offset by unexpectedly adverse COVID-19 variant developments and policy decisions in Washington. Consequently, we believe plan sponsors are well served by maintaining target interest hedge ratios, or, if their risk tolerance and time horizon allow, being slightly underweight. In our clients’ full-discretion liability hedging portfolios, we have approximately 5% less interest rate exposure than their benchmarks, a level similar to the end of last quarter.
Credit Environment Requires Active Management
While credit spreads tend to be mean-reverting over time, a protracted spread environment at current levels would not be unprecedented: in the mid-2000’s, Long Credit spreads remained in the 105-131 bp range for over 3 years, compared to the current Long Credit spread level of 118 bp. Supporting the potential of “lower for longer” spreads are a positive macro backdrop and strong credit technicals. Year-to-date net corporate issuance is lagging that of 2020 but remains on track to exceed both 2018 and 2019 (Figure 2). This supply is being met with ample demand: in addition to corporate plan de-risking, other drivers include insurance companies (with a potential preference for BBB- and BB-rated bonds given recent NAIC risk-based-capital changes), foreign investors taking advantage of attractive U.S. yields even on a hedged basis, and underfunded Taft-Hartley plans investing financial assistance under the American Rescue Plan Act (ARPA) expected later this year. Within investment grade credit, spreads are historically low and comparable across virtually all sectors, with the exception of Energy and emerging market sovereigns and quasi-sovereigns (Figure 3).
Consequently, we believe that a prudent way to hedge credit spreads in the current environment is to maintain credit beta close to that of liabilities (or benchmarks); focus on select higher-yielding issuers (rather than broad credit exposure) balanced with more stable market segments, like taxable municipals; and reserve a modest allocation to Treasuries as “dry powder.” Although a wholesale shift higher in quality may seem logical or attractive, this approach may give up yield advantage relative to the liabilities and not provide a sufficient cushion against spread widening, particularly in extremely low-spread sectors such as government-guaranteed, supranational, and securitized.
Figure 3: Long Duration Credit Spreads
Source: Bloomberg Index Services.
Pension Risk Transfer, ARPA Relief Affect Overall Plan Strategy
According to LIMRA, pension risk transfer (PRT) activity in the first quarter totaled $3.8 billion, a drop of 15% from the first quarter of 2020 and 20% from the first quarter of 2019. Nearly 75% of that activity, or $2.8 billion, is attributable to a single buy-in transaction, suggesting that this year’s PRT activity is not quite yet off to the races. In addition, according to Milliman and October Three, June PRT costs are similar to those as of March and are slightly higher compared to last year-end, perhaps reflecting heightened demand for PRT and insurer selectivity. As always, each PRT transaction is unique and should be evaluated in the context of individual plan sponsor objectives.
Finally, with the enactment of the ARPA pension relief in the rear view mirror, its implications are coming into focus. While the impact is most immediate for underfunded plans, whose minimum funding requirements could fall by as much as half, there are also considerations for well-funded plans with respect to investment risk tolerance, PRT, and the strategic decision between plan termination and hibernation
We would welcome the opportunity to speak with you about your pension risk management objectives in today’s environment.
The above information is not a complete analysis of every material fact concerning any market, industry, or investment. Data has been obtained from sources considered reliable, but Dodge & Cox makes no representations as to the completeness or accuracy of such information. Opinions expressed are subject to change without notice. Information regarding yield, quality, maturity, and/or duration does not pertain to accounts managed by Dodge & Cox. The above returns represent past performance and do not guarantee future results. Dodge & Cox does not seek to replicate the returns of any index. The actual returns of a Dodge & Cox managed portfolio may differ materially from the returns shown above. This is not a recommendation to buy, sell, or hold any security and is not indicative of Dodge & Cox’s current or future trading activity. The securities identified are subject to change without notice and may not represent an account’s entire holdings.
Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance, L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith. The Bloomberg Barclays U.S. Long Credit Index measures the performance of investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate and government-related debt with at least ten years to maturity. It is composed of a corporate and a non-corporate component that includes non-U.S. agencies, sovereigns, supranationals and local authorities.
The MSCI ACWI (All Country World Index) Index is a broad-based, unmanaged equity market index aggregated from 46 developed and emerging market country indices. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This publication is not approved, reviewed, or produced by MSCI.
1 The information in this paper should not be considered fiduciary investment advice under the Employee Retirement Income Security Act. This paper provides general information not individualized to the particular needs of any plan and should not be relied on as a primary basis for investment decisions. The fiduciaries of a plan should consult with their advisers as needed before making investment decisions.
2 One basis point is equal to 1/100th of 1%.