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    Instant Insights: (Un)limited liability?

    Instant Insights: (Un)limited liability?

    March 13, 2020 Global macro, Instant insights
    Coronavirus-related volatility presents liability investors with potentially their greatest headache yet: how expensive can liability obligations get?

    With negative rates potentially on the horizon – the answer is that there could be no limit. The risk is that pension liabilities rise dramatically. Plan sponsors may need to manage that risk more closely.

    Average funded status is down from 88% to 77% year-to-date1

    Volatility can hit a plan’s funded status on both sides of the balance sheet: assets can fall as markets sell off and lower yields can cause liabilities to rise.

    This has been playing out: US equities just entered their first bear market since the financial crisis, and the resulting ‘flight to quality’ has caused long-dated US Treasury yields to capitulate (Figure 1).

    This has also dragged down 30-year AA-rated bond yields (which are used by corporate plans to measure liability obligations for GAAP accounting purposes) by ~80bp (Figure 1).

    Figure 1: Yields (%) have fallen aggressively so far this year1

     

    Figure 1: Yields (%) have fallen aggressively so far this year

    So far this year, we estimate2 the top 100 US corporate DB plans’ liabilities are up 11% while their assets are down by 3%3. This means the average funded status ratio has fallen from almost 88% to 77% – quite a way further from fully funded.

    It can't be ruled out that rates could go lower still

    The worldwide experience indicates that yields can go lower, and even negative. It may be time to avoid complacency. In fact, almost $15tn (or 25%) of global debt already trades at negative yields4. Japanese government yields are negative out to 10-years and the entire sovereign curves of Germany and the Netherlands are also negative (Figure 2).

    Figure 2: European sovereign bond yields5

     Figure 2: European sovereign bond yields

    Even AA corporate yields are negative in Europe and Japan at the front-end. Thirty-year yields are not far behind at 80bp and 60bp, respectively (Figure 3).

    Figure 3: European and Japanese AA yields have gone negative6

    Figure 3: European and Japanese AA yields have gone negative

    Negative yields could push US liabilities up as much as 50-75%

    We have modelled7 how total US private sector pension liabilities would likely respond to European/Japanese yield levels, and even the prospect of negative discount rates.

    Our results indicate that US obligations could rise by 50% to 75% if discount rates fall to a level between 0% and -1% from a current estimated level of ~2.5% (Figure 4).

    Figure 4: A stress test of US pension liabilities8

    Figure 4: A stress test of US pension liabilities

    The curved dotted line shows that the more rates fall, the faster liabilities tend to rise (a phenomenon known as ‘convexity’). This exacerbates the problem for plan sponsors.

    What do negative yields actually mean for pension discounting?

    Negative rates imply that the present value of liabilities is actually higher than the future value. In other words, as your investments are expected to lose value, you need to invest more today than the sum of your future outflows. As bizarre as that sounds, it’s already happening outside the US.

    Can yields really go negative in the US?

    Markets already expect the Fed to slash rates to 0% as soon as April. Last week, Boston Fed President Eric Rosengren also called for a wider scope of quantitative easing (QE) purchases. If the Fed started buying corporate bonds, it would likely put more downward pressure on long-term AA corporate yields (similar to what has occurred in Europe).

    Options pricing additionally reflect a ~25% probability of negative Fed rates by year-end, up from 5% at the start of the year (Figure 5), even considering potential legal hurdles. Although Rosengren was dismissive of negative rates, other voices – such as former Fed chair Alan Greenspan – agree that they can’t be ruled out. Bond yields can also go negative even if policy rates do not, as they did in Europe before a negative rate policy was widely considered executable.

    Figure 5: Markets see negative rates as a real possibility9

    Figure 5: Markets see negative rates as a real possibility 

    Prevention is better than cure

    We believe the most important thing in the face of such extreme asset market and interest rate fluctuations is to remain calm and rational, keeping sight of your long-term goals as you prepare for potentially prolonged market volatility. Market pull-backs are a normal part of long-term investing and can present both risk and new opportunity. When the dust settles, we expect that there will be compelling value once again in many markets, including in high quality sectors of the credit markets.

    Of more immediate concern to us is the potential path for interest rates from here and what it means for liability values and funded status. In our view, while it may be tempting to think the ‘horse has bolted from the stable’ and do nothing to increase protections on the liability side of the balance sheet, we believe that the cost of inaction to plan sponsors could be considerable if lower discount rates do manifest themselves. At this juncture, we therefore recommend that plan sponsors seek to understand the sensitivity of their specific liability cash flow profiles to lower rates and consider the range of hedging strategies available to lower exposures or to ‘stop-loss’.

    Additionally, we expect liquidity and cash flow matching strategies to come into much more focus going forward. Forced selling of risk assets in volatile down markets (in order to meet benefit outflows) can permanently impair long-term returns. We advocate setting aside a dedicated liquidity pool or developing a cash flow matching strategy to protect against value destruction.

     

     


    1Bloomberg as of March 9, 2020.

    2Insight calculations based on the top 100 largest corporate DB US pension plans (sourced from Bloomberg), March 9, 2020.

    3Gains in fixed income have likely offset some equity/risk asset losses.

    4Bloomberg as of March 9, 2020.

    5DB Global Reserach, February 28, 2020.

    6Insight, ICE. Yields as of March 4, 2020.

    7Insight estimates year-end 2019 US liabilities at $3.5tn (based on Federal Funds data for Q3 2019 and published in January 2020), valued at a ~3% average discount rate (based on FTSE Pension Liability Index discount rates as of December 31, 2019) corresponding to 13 year durations (based on Bloomberg data from the top 100 pension plans).

    8Insight calculations based on Bloomberg and Federal Reserve data, January 2020. This analysis assumes that the pension liability has a duration of 13 and a discount rate of 3% (estimates based on data from the 100 largest US pension plans), and a present value of $3.5tn (based on Federal Funds data). Where model or simulated results are presented, they have many inherent limitations. Model information does not represent actual trading and may not reflect the impact that material economic and market factors might have had on Insight's decision-making.

    9Bank of America Merrill Lynch Research, March 11, 2020.

    Please note: any forecasts or opinions expressed herein are Insight Investment's own as of March 12, 2020 and subject to change without notice. This information may contain, include or is based upon forward-looking statements. Past performance is not indicative of future results. 

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