While the four-year bull market in bonds has been a blessing for many investors, it has played havoc with the actuarial assumptions used by pension fund sponsors to determine how to provide for the needs of future retirees.
As recently as five years ago, even relatively conservative sponsors were assuming annual rates of return around 10%. At the time, gains of this magnitude could be generated without a lot of investment pyrotechnics - 10-year Treasury bonds were yielding 9.2%; mortgage-backed securities, 10.3%; and single-A industrials, 10.7%. Without moving away from the investment-grade mainstream, double-digit returns easily were within reach.
Then, beginning in 1990, the bond markets began a rally that is only recently beginning to show signs of fatigue. Plan sponsors initially were delighted with this turn of events, as rapidly appreciating portfolios promised to ease their funding burden. However, as the rally continued, yields on the 30-year Treasury were pushed to the lowest levels since the bond began selling in 1977 (in October 1993, the 10-year Treasury hit its lowest yield in 26 years). As new assets flowed into the plans, internal rates of return fell, raising the specter of shortfalls sometime after the turn of the century.
This created something of a dilemma. On the one hand, lower projected rates of return meant an increased funding liability for the sponsor - at the same time many corporations were laying off employees in an effort to boost profits. On the other hand, generating the returns originally built into the plans appeared to require an unacceptably high level of risk, something many fiduciaries were reluctant to do.
As plan sponsors wrestled with this problem, we began to analyze its implications. In reviewing pricing data for the past five years and comparing the relative performance for various classes of credits based on our proprietary default risk rankings, we identified the portion of the market where risk/reward ratios were optimized, combining strong total returns with relative safety of principal. We defined the sector, which incorporates approximately 175 credits, as "midgrade." In credit quality, it ranges from the equivalent of strong BB to as high as a vulnerable A and includes some of the best-known names in corporate America: Occidental Petroleum Corp., Philips Petroleum Co., USX Corp., Chrysler Corp., Digital Equipment Corp., Owens-Illinois Inc., RJR Nabisco Inc. and McDonnell Douglas Corp.
Balancing risk and reward
Traditionally, pension fund managers have not been major participants in the high-yield markets, which generally were thought to be too risky. This conservative approach was apparently borne out in 1989 and 1990,when the high-yield market suffered a severe contraction. The turbulence, viewed darkly at the time, turned out to be temporary. In 1991 and 1992, the high-yield market rallied, returning 59.41% and 20.28%, respectively, for cash pay bonds, and outperforming virtually every other sector worldwide.
Yet the market didn't behave monolithically, as the midgrade sector exhibited a set of characteristics with high intrinsic appeal to pension fund sponsors and other institutions. In 1993, the group posted a total return of 14.98%, on relatively low volatility, compared to 16.69% for the high-yield market (which includes the midgrade credits). Looking back to 1989, midgrade credits have returned a compound-average 12.47%, compared with 15.41% for the high-yield market and 11.82% for 10-year Treasuries. On a weighted average basis, the total return for midgrade credits in 1993 was 16.91%, compared to 19.42% for high-yield credits.
This performance relationship has held steady in both up and down markets. As the accompanying chart shows, the midgrade sector traditionally has had a much narrower and more consistent spread to Treasuries when compared to the universe of all cash-pay high-yield bonds. In the 1989-'91 sell-off, the spread for all cash-pay high-yield bonds widened by more than 1,000 basis points, while midgrade bonds widened by less than 200 basis points. In fact, in every year since 1989, our index of midgrade bonds has provided a positive return. The return was in double digits every year except 1990, when it was a respectable 7.7%. This compares very favorably with a loss of 12.68% for the high-yield sector that same year.
Debt securities in the investment-grade sector historically have traded at a spread to comparable Treasury bonds, with prices influenced more by overall interest rate levels than by credit considerations. However, as more institutions move into the midgrade sector to optimize yield while seeking to enhance principal, the market has become more transaction-oriented, with a greater need for research anticipating movements in bond prices.
As is the case with high-yield credits, variation in returns among individual bond issues is substantial. For example, in 1993 the best-performing midgrade bonds (Hospital Corp. of America and Telecommunications Inc.) had total returns exceeding 30%. On the other end of the spectrum, the poorest performing bonds in the universe (Mitchell Energy & Development Corp. and Seabrook) had total returns between 5% and 6%.
The key to outperformance is finding the proper balance between credit risk (as opposed to market risk) and yield. This requires a forward-looking assessment of company and industry fundamentals, including management strategy, capital spending, financing plans and other variables. Then, by comparing the indicated returns from a company's bonds with those of other companies in the industry and of similar credit risk, overvalued and undervalued bonds can be identified.
The need to perform
Recent studies of the private pension system have underlined the threat to beneficiaries (and by implication, to plan sponsors and their selected asset managers) posed by long-term underperfor-mance. Investor willingness to exploit the midgrade credits will provide a good first step in resolving the funding dilemma.
Kingman D. Penniman is director of fixed-income research at Duff & Phelps Investment Research Co. , Montpelier, Vt.