Rising Interest Rates are Humbling for Bond Funds and Their Managers!

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Last week, The Wealth Advisor published an article highlighting the onerous impact of rising US interest rates on the performance of large (>$1 billion) bond funds, which were screened using data compiled by Bloomberg and Morningstar Direct and excluded short-duration offerings. There were 198 funds that were identified and from that universe, it was determined that only two - T. Rowe Price Dynamic Global Bond Fund and the JPMorgan Strategic Income Opportunities Fund (3.4% and 0.3%, respectively) - had produced a positive return in 2022 as of the date of the article 12/21/22. This news isn't shocking, as we understand that interest rate risk is the single greatest risk for bonds.

Fixed-income managers have enjoyed nearly four decades of declining US interest rates. That tailwind, which fueled superior performance, has been replaced by a significant headwind that threatens to blow for quite some time to come. How will plan sponsors and their consultants react to this shifting landscape? Will they continue to use core and core plus bond mandates as performance instruments or will they determine that the best use for fixed income is in the certainty of their cash flows? Those cash flows can be modeled to meet ongoing benefit payments and plan expenses chronologically from the next month's liquidity needs as far out as the allocation can fund. The beauty of this implementation is the fact that benefits and expenses are future values that are not interest rate sensitive.

One can effectively use bonds through a cash flow matching strategy (aka CDI) without fear of the Fed and how their policy decisions might negatively impact bonds. This "sleep-well" at-night strategy has been time-tested for decades.  It was called Dedication in the 1970s and 1980s. Through this implementation, plan sponsors have now bought time (expanded time horizon) for all of the alpha assets in their portfolios to grow unencumbered. Why make a bet on where rates are going? Just eliminate interest rate risk by adopting a CDI implementation. You can now sit back on FOMC announcement days without fear of what the Fed will say. How comforting!

This is NO Time to be Greedy - revisited

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Producing posts/articles on the Ryan ALM, Inc. blog has been very rewarding for me. I've now produced more than 1,160 posts that date back 2019 when I joined Ryan ALM and prior to that during my days at Kamp Consulting Solutions (KCS). Producing a blog on a fairly regular basis is challenging in that I want to make sure that what we produce is relevant and helpful for the pension/investment industry. I hope that it has proven to be. Furthermore, there is also no place to hide! Everything that has been produced is there for all to see on the Ryan ALM web site www.RyanALM/Insights/White-Papers.

I have great respect for the people in our industry but often find myself challenging how pension plans are operated, which seems to be driven by the status quo. After more than 41-years in this business I've come to the conclusion that given each plan's unique liability stream, it is critically important that a custom solution be created to ensure that the plan's benefit promises (liabilities) to its participants are SECURED at both a reasonable cost and with prudent risk.

It is fine to claim to be a long-term investor, but it is another thing not to react to a market environment that appears to be entering a watershed event, which don't present themselves often. The nearly 40-year decline in US interest rates from 1982 that fueled the massive equity and bond returns during that period of time had gotten long in the tooth despite the incredible returns posted by US equity markets in 2021. I highlighted my concerns in a November 22, 2021 post titled "This is No Time to be Greedy". My concerned centered on the fact that asset allocations had gotten much more aggressive and allocation to both bonds and cash had been significantly reduced.

I said, "the thought that fixed-income assets could be a source of liquidity when equity investments were under pressure was a very reasonable assumption during the last 39 years of a bull market for bonds. However, the next equity market crash may be driven by inflationary pressures forcing US interest rates higher. In that case, all bets are off as to the ease by which bonds can be sold and cash raised! I further stated, "bonds should be used for their value… the certainty of their cash flow - period! "An additional benefit (of cash flow matching) includes the mitigation of interest rate risk on the portion of the portfolio that is being defeased through CDI, as cash flows are funding future benefits which aren’t interest-rate sensitive."

Pension plans' fund status had improved, and funded ratios were more elevated than they'd been in years. I challenged those in the pension industry to not sit idly. That after 40 years of easy money we were about to experience a paradigm shift that would significantly impact pension America. The US Federal Reserve doesn't believe that the current inflation is transitory. As such, they are committed to raising US interest rates until they have accomplished the job of getting inflation back to 2%, whether or not you believe that is the right objective. Given strong employment and wage growth, the Fed has their job cut out for them. This idea that the Fed will engage in a great pivot seems unreasonable. Core inflation remains too high, US rates are likely to continue to rise putting additional pressure on return-seeking fixed income strategies and equities. Have you prepared your portfolio to deal with this likely reality? There was an opportunity at the end of 2021 to take some risk off the table. Are we going to miss another opportunity in 2022? We, at Ryan ALM, urge pensions to separate liquidity assets from growth assets. Let the fixed income allocation be the liquidity assets that buy time for the growth assets to grow unencumbered!

SECURE ACT 2.0 - Should We Get Excited?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

SECURE ACT 2.0 continues where the SECURE Act ended following its 2019 passage. There is a lot to this legislation We will be touching on various aspects of this legislation to discuss how it helps Americans in their quest to achieve a dignified retirement and where it might fall short.

In order to better understand aspects of this legislation, I reached out to my friend Kendra Isaacson, Pensions Policy Director and Senior Tax Counsel at Senate HELP Committee for Senator Patty Murray, Chair, who with other members of her team were able to shepherd through this legislation and get it included into the Congressional Omnibus Spending Bill. Kendra shared her favorite aspects of the bill, including the following: "I am the most excited about the pension-linked emergency savings accounts. Our theory is that this will draw lower-income, new participants in the retirement system who may have been nervous about locking their money up in a retirement plan." I couldn't agree more that this is an important step forward.

For years, I felt that DC offerings were nothing more than glorified savings accounts that were often raided by participants experiencing financial hardship. Having a "side pocket" for emergency purposes is an outstanding enhancement that hopefully encourages lower-wage earners to establish a retirement account. According to Kendra, "it is designed that employers would match into the associated defined contribution plan so participants can have an emergency savings account for short-term needs while working on their long-term retirement savings." Again, this is a wonderful step forward IMHO.

I can assure you that there are individuals on both sides of the aisle that have great concerns about whether or not this legislation goes far enough. As stated earlier, we will continue to highlight the pros and cons in future blogs. Until then, let's celebrate Kendra and her committee's accomplishments.

Do These Data Releases Impact 2/1/23 Fed Actions?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Interesting data releases today. 

On the one hand, we have existing home sales data that came in light at 4.09 million (annual units) relative to forecasts of 4.17 million for the 10th monthly decline in a row. This got equity markets rallying as investors cheered the slowing housing market and the potential impact that has on interest rates (down). But we also had the monthly release of the Consumer Confidence Index that came in hot, blowing away expectations at 108.3 vs. 101.2! Since there is a positive correlation between sentiment and spending, bond markets have begun to sell off. Treasury yields which had fallen to start the day are basically flat at this point. 

What will the Fed do? Do we have an environment in which the consumer has shifted their spending away from housing to other goods and services, especially services, making the Fed's job more difficult in fighting inflation, or is the dramatic fall in housing activity a prelude to collapsing spending? Equity investors would have you believe that the Fed will soon realize the error of their way and begin the great pivot, while bond investors remain far more cautious. Of course, only time will tell, but it is always interesting to see what drives markets and investors' actions.

Ryan ALM: Believe it or Not

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Occasionally, we at Ryan ALM stumble over a fact or two that surprises us, and we like to bring it to the attention of our readers of this blog. Obviously, inflation and the impact of these inflationary pressures have been a dominant force within the US markets in 2022. Aggressive US Federal Reserve policy action (perhaps a bit late) has driven interest rates upward (FFR +4.25%) from historically low levels creating great uncertainty regarding the near-term implications for the US economic environment. Debate rages over the likely outcome with participants arguing about the potential for a hard or moderate recession or the Goldilocks soft landing.

Much debate has also focused on the primary source(s) of US inflation. Was it the stimulus provided to prop up our economy during the initial Covid-19 response or was it the disruptions to our ability to meet heightened demand as a result of global production disruptions, including the impact from both Covid-19 and the Russian invasion of Ukraine? There's good reason to believe that both contributed to the four-decade-high inflation experienced in 2022, which makes the argument that inflation is transitory more difficult to accept.

Fact 1: In the nearly three-year period of 2020 to YTD 2022, the US has injected $6.8 trillion in net Treasury Bills, Notes, and Bonds into our economy. During the GFC (2008) and for 4 years subsequent, the US injected "only" $6.4 trillion in net Treasury debt to help the economy get back on solid ground from the most harmful recession that our nation had experienced since the Great Depression of the late '20s to mid-'30s. That is a tremendous amount of stimulus that continues to work its way through the system. In addition, we have one of the strongest labor markets at this time with unemployment continuing to remain quite low at 3.7%, while annual wage growth hovers in excess of 6% as of November 2022. Yes, inflation has moderated during the last several months, but it continues to remain quite elevated relative to the Fed's target level of 2%. Given the extraordinary stimulus and strong labor market, it is likely that a more aggressive stance by the Fed will be needed to finally eradicate inflation... not to mention the Fed's intention to create real rates or an inflation premium which has averaged 3.04% since 1960.

One last observation (fact 2), in reviewing the history of Treasury issuance since 2000, it continues to surprise me that the US only issued $510 billion of gross Treasury Bonds during 2020 relative to the total gross issuance of nearly $21 trillion in Treasury debt (2.4% of total issuance) when the yield on the 30-year bond had fallen to 1.28% during the initial reaction to Covid-19. Why would you not extend maturity when rates were at historically low levels and not likely to fall any further? Instead, the US Treasury has had to refinance trillions in $s at ever-increasing interest rates? This scenario is likely to continue well into 2023 as the Fed appears committed. What a wasted opportunity.

ARPA Update as of December 16, 2022

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Happy Hannukah, Merry Christmas, and Happy Holidays! We wish you a wonderful holiday season.

We are pleased to provide you with the latest activity related to ARPA's implementation. There were no new or supplemented applications filed with the PBGC during the most recent week. However, the PBGC was busy approving two supplemental applications for the Teamsters Local 617 Pension Plan and the Graphic Arts Industry Joint Pension Plan, which will receive additional SFA funding amounting to $31.0 mil and $82.2 mil, respectively. This additional funding will further secure the promises for 10,745 plan participants.

There are currently 30 applications that have been submitted to the PBGC that have yet to be approved with 12 of those being initial applications and two more that were revised and resubmitted. As a reminder, the window is currently open for Priority Group 5 plans (projected to become insolvent before 3/11/2026) with Priority Group 6 plans slated to become eligible to file an initial application beginning February 11, 2023.

The data above reflects the activity of multiemployer plans submitting an initial or revised application through December 16, 2022. Despite the good work to date from the PBGC, there is plenty left to accomplish. Next year should prove to be quite active as the bulk of potential ARPA/SFA recipients has yet to file.

Still Not A Believer?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

There appears in today's WSJ an article by James Mackintosh titled, "The Markets Don't Believe the Fed". It is incomprehensible to me that this continues to be the mindset of the average investor given the fact that the Fed controls short-term US interest rates. Whether you believe that the economic fundamentals exist to support aggressive interest rate policy, the Fed is in control. I began posting blogs about "believing" the Fed in March 2022. My first post, "You Should Believe The Fed" stated that "we (Ryan ALM) are NOT in the habit of forecasting rates, but after a 39-year bull market for bonds that produced historically low absolute and real interest rates, we felt pretty comfortable in our expectation" that US interest rates would rise.

I further wrote, "if you don’t believe us, I highly recommend that you listen to the US Federal Reserve, as they came out very aggressively yesterday (March 16th) and indicated that the 25 basis point move in the Fed Funds rate (first increase since 2018) would be followed by 25 bps increases at each of the remaining six meeting in 2022. Incredibly, those 25 bps increases didn't occur, because they were superseded by a 50 bps increase, four 75 bps increases, and finally earlier this week another 50 bps elevation in the Fed Funds Rate (FFR)!

I went on to ask "is your portfolio structured to withstand this aggressive move upward in rates? What have you done to secure the promised benefits? If nothing has been done, are you prepared for deterioration in the plan’s funded status and increased contribution expenses? This is the reality that our pension industry is facing." Regrettably, most sponsors and their consultants have done little to nothing to protect and secure the promised benefits. Expectations now exist that the Fed will raise the FFR to a level that exceeds 5% given the stickiness of "core, core" inflation and concerns that an easing in its restrictive policy might just result in a similar and painful outcome to what was experienced during the late '70s and early '80s.

Given the reluctance on the part of market participants to believe the Fed, long-term interest rates have fallen significantly during the last couple of months creating an environment of easier money conditions similar to what we witnessed earlier this year. 30-year mortgage rates are once again below 6.5% having peaked at 7.1% during this rate cycle. With long rates in the mid-3% range, just how much economic activity will be thwarted? The US labor market remains strong and wage growth remains well above the level desired by the Fed. Initial jobless claims, which had recently been elevating, came in 20,000 below forecast to a low level of 211,000.

I believe that it is fair to ask, "what has the Fed accomplished to date"? Their policy actions certainly haven't driven inflation anywhere close to the desired 2% target. It appears to me that the Fed has much more work to do. Will market participants finally believe them? As we witnessed in 2022, you ignore the Fed at your own peril.

Cash Flow Matching (CFM): Eliminates the Need to Hold One's Breath

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

While the investing community holds their collective breath in anticipation of the latest US Federal Reserve Fed Fund's Rate announcement, those plan sponsors using cash flow matching (CFM) can sit back knowing that interest rate movements provide little impact on their bond allocation that is used to defease their plan's liabilities. How comforting! Despite the significant interest rate gyrations in 2022 that saw US rates rise rapidly through October (US 30-year Treasury Bond yield peaked at 4.34%) only to pull back as long-bonds recently rallied (US 30-year Treasury Bond yield is at 3.54% today), CFM is doing exactly what it proclaims to do. Importantly, the CFM portfolio is providing the necessary liquidity to meet monthly benefits and expenses, while the bond's assets and the pension's liabilities track very closely minimizing the impact on a plan's funded status and contribution volatility.

We are quite fortunate to work with an array of clients who have asked us to cash flow match pension liabilities covering various lengths of time from 3 years to 30+ years. Since every client's liabilities are different, there is no "standard" portfolio that is built by Ryan ALM, as we need to carefully match each client's unique liability cash flow needs with bond cash flows of interest and principal (and reinvested interest income). For the first 9 months, bond asset values fell as rates rose, but so did the present value of pension liabilities that are bond-like in nature. For the two months since the current peak in rates, both assets and liabilities have seen their values rise. On a year-to-date basis through November 30, 2022, both assets and liabilities are down modestly, with a representative Ryan ALM CFM bond portfolio showing "alpha" of about 80 bps, as our yield advantage (skewed to A/BBB corporate bond exposure) buffers the portfolio versus the plan's liabilities valued using a AA custom liability index (ASC discount rates).

As we've reported on numerous occasions in our blog, total return core or core plus bond programs managed against the Bloomberg Barclays Aggregate Index (-12.62% through 11/30/22) have suffered significant asset underperformance in 2022 as US interest rates rose significantly. Furthermore, these portfolios are not designed to provide the liquidity necessary to meet monthly benefits and expenses so bonds and other assets must be sold in order to meet those cash needs. Many pensions do a cash sweep of all assets including performance assets (i.e. dividends from stocks). This is troubling in down markets such as those that we've experienced this year when losses are realized.  Wouldn't you like knowing that come 2:30 pm you can sit back and not worry what the Fed is going to say or do? It is comforting knowing that your pension liabilities have been secured through a CFM mandate, which mitigates interest rate risk since benefits are a future value and future values are not interest rate sensitive. We'd be happy to model your plan's liabilities to see how CFM can help you.

Wage Growth Doesn't Portend Falling Inflation

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

We've mentioned "inflation" in 50 blog posts just since July 1, 2022. It is clearly on our minds and the minds of 99% of the investment community. What is our position? We are certainly not in the camp that inflation has been tamed and that the Fed's 2% target is right around the corner. Our argument is quite basic. Given the strong labor market and rising wages, demand for goods and services will remain strong. Does this mean no moderation in our inflationary environment? No, it doesn't mean that, but we don't expect a dramatic reduction in inflation anytime soon, as many on Wall Street are predicting.

As the graph above highlights, wage growth continues to trend upwards. When people are working and earning greater wages, they demand more goods and services. The impact on inflation from Covid-19 production shortfalls and stimulus may be working through the system, but the Ukraine/Russia conflict is far from over and the outcome is certainly not known at this time. These impediments have certainly created supply and demand imbalances, but they are dwarfed in importance by 3.7% unemployment and 6% wage growth. Little evidence exists at this time that would lead one to believe that we are going to see a dramatic collapse in our current labor force. In my post from last week, I highlighted the fact that the Federal Reserve didn't get its arms around inflation which started to spike in 1978 until 1981 when long rates were near 10% and unemployment was at 8.5%. Our current environment doesn't come close to reaching those levels.

Lastly, rates have risen from historically low levels, but do you really believe that a 30-year Treasury bond yield of 3.57% (2 pm on the 12th) is going to curtail economic activity? My first house was purchased with a mortgage rate of >11% because I needed a place to live. What we wouldn't have given to be able to finance that home at 6+%, which is today's level.

ARPA Update as of December 9, 2022

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

The PBGC certainly didn't let the upcoming holiday season get in the way of some important business. As we mentioned in last week's update, there was a potential "tidal wave" of activity facing the PBGC team, as one revised application and 11 supplemental submissions were reaching the 120-day threshold for action. The one revised application was the mammoth Central States plan that received approval for nearly $36 billion in Special Financial Assistance (SFA). The SFA payout is slightly more than $100,000 per plan participant (357,056) and it goes a long way to establishing a firmer financial footing.

The 11 supplemental plans each received approval for their applications. In total, these plans will receive an additional $704 million covering 101,860 plan participants. To date, $45.4 billion has been allocated to 37 pension plans, with Central States representing roughly 80% of the SFA payout to date. Estimates vary as to the ultimate SFA payout, but a safe guess would be that at least 50% of the ARPA proceeds have been allocated and disbursed.

In addition to the activity mentioned above, the New York State Teamsters Conference Pension and Retirement Fund submitted a supplemental application seeking an additional $421.3 million for their 33,643 plan participants. This fund had previously received $963 million as a Priority Group 2 plan. Also, there are two more funds, Teamsters Local 617 Pension Plan and the Graphic Arts Industry Joint Pension Plan, whose supplemental applications are hitting the 120-day window for PBGC action during the next week.

Finally, congratulations to all of those individuals and organizations that worked tirelessly during the last decade-plus to secure the funds necessary to secure the Central States pension system. It would have been so easy to throw in the towel by using MPRA to slash the promised benefits. As a result of this effort, many Americans will once again receive the promised benefits allowing them to begin a more dignified retirement. Great job!