Yield hike has institutional investors anticipating a new dawn
By Arleen Jacobius | February 4, 2013
Institutional investors knew this day would come, but not so soon and not at as quick a pace.
After years of persistent low interest rates and correspondingly low corporate and Treasury bond yields, the 10-year Treasury bond yield surpassed 2% intraday on Jan. 28. If sustained (it was 2.02% on Feb. 1), that could alter everything from discount rates and funding to asset allocations.
The yield on the benchmark 10-year Treasury was last above 2% in April 2012.
The move is welcome news for corporate pension executives and other institutional investors because the corporate bond yields used to calculate discount rates are rising too.
And if yields — and interest rates overall — continue to rise, the number of corporate defined benefit plans transferring pension risk by buying group annuity contracts to cover future benefit obligations or making lump sum distributions from the plan could also increase, insiders say.
“Discount rates, which are based on corporate and not Treasury rates, are up. This means you are dividing by higher a number, which is good,” said Matthew E. Stroud, head of strategy and portfolio construction in the New York office of Towers Watson Investment Services Inc.
“Pension fund financial health ... would be stronger,” he said. “Assets up and liabilities down a little bit puts pension plans in a stronger position, all else being equal.”
Sean Brennan, principal in the financial strategy group, Mercer, New York, noted that liabilities have not dropped as much lately as they typically would have during a recovery. Often, when interest rates rise, liabilities will go down, he said.
“Liabilities have come down some; however, since credit spreads tightened, they didn't come down as much,” he said. “Treasuries and credit spreads have been partially offsetting each other recently in terms of corporate discount rates.”
Since the end of 2012, Treasury yields rose more than spreads tightened, Mr. Brennan said.
Indeed, in 2012, liabilities of corporate defined benefit plans rose 10% because interest rates fell, even though returns on assets for the year were 12.86%, according to data from Norwalk, Conn.-based consulting firm Rocaton Investment Advisors.
Not an aberration
Some investment strategists do not think the current uptick in Treasuries is an aberration but the beginning of a sustained increase in interest rates. Rocaton expects interest rates to continue to rise, with the 10-year bond yield edging up to around 5% in five years.
Rising interest rates could cause an upsurge in the number of corporate pension risk transfers, said Joseph Nankof, consultant and partner at Rocaton.
“Rising rates for any plan sponsor that believes rates will be higher than they are today would make it more attractive to pursue the lump sum or annuity purchases,” he said.
Higher rates would result in lower costs. Plan sponsors would rather wait for rates to rise because their pension plans would pay less, Mr. Nankof said. On the investment side, nobody is suggesting that investors redo asset allocations just yet. If the movement persists, that could affect some plans' asset allocations. For one thing, the prevailing view of a low-yielding economic environment has led investors to look to real assets and private credit to fill in a portion of the spot that used to be taken up by fixed income.
At the same time, pension plan portfolios had double-digit returns in 2012, with equities in the lead, Mr. Stroud said.
Still, Towers Watson officials don't see the movement in the 10-year Treasury changing the big picture for pension funds' asset allocations, because “the cash rate is nailed to the floor and so sitting in cash is not an option because yields are zero,” Mr. Stroud said.
So, the increase in the U.S. Treasury rate is a good rationale for hedging liabilities to enable risk in other parts of the portfolio because long-term bond rates — while up — are still low.
Indeed, the timing and speed of the increase in rates came as a surprise to many, at least according to annual surveys taken by Towers Watson of about 150 industry executives including money managers and economists.
Survey respondents indicated they expected interest rates to rise in 2010 and again in 2011. By the 2012 survey, respondents were not so sure, he said.
“We expected interest rates would rise anyway, but it is a little faster than we and others thought,” Mr. Stroud said. “How much faster ... we will see at (first) quarter's and year's end.”
In a showing of how fickle economic recovery can be, gross domestic product datareleased Jan. 29 showed that the economy was shrinking for the first time since the Great Depression.
Even so, if the economic recovery persists and defined benefit plans' funded status continues to improve, some pension plans could move more assets into fixed income, Mercer's Mr. Brennan said. “Funded status improved subtly and if it persists, pension funds could improve further and may look to transition more assets to fixed income.”
Rocaton's Mr. Nankof said the rise in Treasuries cemented some corporate pension executives' views that interest rates “are poised to rise and it is not a great time to pour money into long bonds.”
Instead, they are considering higher-returning investment options including replacing long-duration bonds with shorter ones that are less susceptible to rising rates.
Those willing to take on the risk are investing in equities, Mr. Nankof said. Another, newer possibility is investing in middle-market direct lending, which adds credit and illiquidity risk but “offers considerably higher returns than core fixed income and long bonds and not as much risk as equities.”
This article originally appeared in the February 4, 2013 print issue as, "Yield hike has investors anticipating a new dawn".