Insights on INFLATION AND FIXED INCOME INVESTMENTS · large debt burdens and the economy’s...

northerntrust.com | The Specter of Rising Interest Rates | 1 of 16

Insights on...INFLATION AND FIXED INCOME INVESTMENTS

1%

3%

5%

7%

9%

11%

13%

15%

-3%

0%

3%

6%

9%

12%

15%

18%

10 Yr % (Left)Int Term Government Bonds Total Return (Right)

1954

1957

1960

1963

1966

1969

1972

1975

1978

1981

Northern Trust Global Investments50 South La Salle StreetChicago, Illinois 60603northerntrust.com

James D. McDonaldChief Investment [email protected]

Richard C. Campbell, CFASenior Investment Program [email protected]

Daniel J. Phillips, CFAInvestment [email protected]

SUMMARYIn the wake of the 2008 financial crisis, global central banks flooded the financial markets with liquidity in an effort to restore financial stability and set the stage for economic recovery. The scale of the intervention, accompanied by widespread budget deficits among developed economies, has raised investor concerns about inflation and fixed income investments. With interest rates near historic lows, many investors believe they can only move up from here, and some are now choosing to hold cash in lieu of a diversified bond allocation. But avoiding fixed income is not a risk-free endeavor. Because we do not expect a significant acceleration in inflation in developed regions like the United States, Europe and Japan, and as current bond prices already incorporate an expectation of rising interest rates, we think the current risk of owning fixed income is probably lower than some investors might think.

EXHIBIT 1: POSITIVE BOND RETURNS DESPITE CLIMBING INTEREST RATES

U.S. 10 Year Treasury Yield vs. Intermediate Government Bond Total Return

Source: Bloomberg, Ibbotson, Northern Trust Global Investments. Past performance is not indicative of future results.

For corporate pension plans, any eventual increase in investment-grade interest rates tends to have a smaller negative effect on the value of plan assets and a larger positive effect by reducing the present value liability of future benefit obligations. In the low-rate environment of the last three years, plan sponsors who believe that rates are more likely to increase than decrease have

T H E S P E C T E R O F R I S I N G I N T E R E S T R A T E S

April 19, 2011


Headline CPI%10 Year %

1954

1958

1962

1970

1974

1978

1982

1986

1990

1994

2010

2006

2002

1998


1954

1958

1962

1970

1974

1978

1982

1986

1990

1994

2010

2006

2002

1998

Exhibit 2: Interest Rates vs. In�ation

-5

0

5

10

15

20

25

-5

0

5

10

15

20

25

1966

1966

The last time investors witnessed significant deflation in the United States was at the start of the Great Depression, when deflation compounded at more than 8% annually from 1930 to 1932.

understandably chosen fixed income investments having far lower sensitivity to interest rate increases than the rate sensitivity of their pension liability. The final sections of this commentary illustrate the impact of interest rate increases on pension funding ratios and consider the use of pension funding ratio as a potential guide to extending duration.

The financial crisis of 2008 and resulting recession forced the major global central banks to combat the threat of a deflationary spiral. The last time investors witnessed significant deflation in the United States was at the start of the Great Depression, when deflation compounded at more than 8% annually from 1930 to 1932. As prices fall in a deflationary episode, profit margins are squeezed and companies begin to unload workers, who in turn reduce their demand for goods and services, thereby reinforcing the deflationary spiral. Fear of a repeat performance led the Federal Reserve in 2008 to drop the federal funds rate to 0.25% and to purchase more than $1.5 trillion of Treasury bonds and government-backed mortgages. The monetary stimulus has worked so far, with a significant improvement in the health of the financial system and economy. But the outlook for global interest rates is becoming increasingly bifurcated between advanced economies – whose high debt levels slow growth – and emerging economies – whose stronger economies are already facing inflationary pressures due to commodity price pressures and capacity constraints.

WHAT DRIVES INTEREST RATES? START WITH INFLATIONA longer view of history offers some perspective on interest rates. We have chosen to highlight interest rates from the United States and United Kingdom as two of the most mature bond markets. We also believe that, with the commonality of bond math, the lessons are universal. A profound secular trend stands out over the last 85 years. U.S. interest rates were low in the 1940s following the Great Depression and gradually rose, peaking in 1981 after a binge of inflation, then slid for nearly 30 years as Federal Reserve policy reduced managed inflation expectations. We can break the nominal yield down into its two components – inflation and the real rate of interest – and test correlations to gain insights into the drivers of nominal rates.

EXHIBIT 2: INFLATION OUTLOOK DRIVES INTEREST RATES

Interest Rates vs. Inflation – United States

Source: Bloomberg, Haver, Office for National Statistics, Measuring Worth, Northern Trust Global Investments.


With banks requiring tighter underwriting, there is no easy channel for liquidity to rapidly enter the real economy, and tepid aggregate demand and spare capacity will likely keep inflationary pressures at bay.

EXHIBIT 2: INFLATION OUTLOOK DRIVES INTEREST RATES (cont’d)

Interest Rates vs. Inflation – United Kingdom

Source: Bloomberg, Haver, Office for National Statistics, Measuring Worth, Northern Trust Global Investments.

Over the full period, the real rate of interest and the inflation rate equally explain nominal interest rates. But in the 30-year run up to peak rates in 1981, inflation almost totally explained rising interest rates, as it did during most of the cyclical spikes as well. This suggests that future inflation may primarily drive major unexpected changes in future interest rates, and fixed income investors should pay particular attention to inflation expectations.

Despite significant liquidity provided by the Federal Reserve, much of it remains on bank balance sheets and has not entered the real economy. Consumers continue to work down relatively large debt burdens and the economy’s productive capacity remains significantly underutilized. With banks requiring tighter underwriting, there is no easy channel for liquidity to rapidly enter the real economy, and tepid aggregate demand and spare capacity will likely keep inflationary pressures at bay. The lack of credit creation has led to moderate growth in the money supply (up 4.7% in the first quarter). As Milton Friedman espoused in his leading research, including “Money Mischief,” Harcourt Brace, 1994, inflation occurs when the quantity of money rises appreciably more rapidly than output. During the inflationary period in the United States from 1969-1979, money grew at an average pace of 9% per year, while output rose 2.8%, helping to generate a 7% average annual rise in prices. During the German hyperinflationary period after WWI, the money supply grew at a rate of more than 300% a month for a year.

The 10-year breakeven inflation rate – arrived at by subtracting the 10-year nominal Treasury bond yield from the 10-year inflation protected bond (TIP) yield – is an unbiased, market-based estimate of future inflation over the next 10 years. Exhibit 3 displays the forecasted 10-year breakeven inflation rate from before the financial crisis through the end of 2010. The forecast for 10-year inflation before the crisis was about 2.5%, just under the long-term average inflation rate of 3% from 1926 to 2010. Inflation expectations plummeted as investors feared a deflationary spiral in 2008. With financial stabilization and economic recovery, inflation expectations grew to 2.6% today, whereas investors faced 8.7% annual inflation over the 10-year period ending in 1982. While markets have now put deflation in the rearview mirror, we believe Fed Chairman Ben Bernanke still worries about the risk that the economic recovery is not self-sustaining – and if it falters, deflation concerns could resurface.


1954

1958

1962

1970

1974

1978

1982

1986

1990

1994

2010

2006

2002

1998


1954

1958

1962

1970

1974

1978

1982

1986

1990

1994

2010

2006

2002

1998

Exhibit 2: Interest Rates vs. In�ation

-5

0

5

10

15

20

25

-5

0

5

10

15

20

25

1966

1966


EXHIBIT 3: DEFLATIONARY WORRIES IN THE REARVIEW MIRROR

10 Year TIPS Breakeven Rate

Source: Bloomberg, Northern Trust Global Investments.

Just as you can gauge investor inflation expectations by the TIPS market, economists scrutinize consumer surveys of inflation expectations – specifically, the University of Michigan Surveys of Consumers. Longer-term expectations of inflation (the next five to 10 years) are an important indicator of future inflation trends, as workers seek increased wages in an attempt to adjust to rising price levels. The effects of short-term spikes in food and energy prices tend not to move longer-term expectations. The recent jump in commodity prices has raised near-term inflation expectations but has affected longer-term expectations less substantially. Since the early 1990s, the U.S. consumer has had a relatively steady expectation of 3% annual price increases.

EXHIBIT 4: IF YOU WANT INFLATION, YOU NEED TO EXPECT IT

Inflation Metrics


-3%

0%

3%

6%

9%

12%

15%

1979

1984

1989

1994

1999

2004

2009

Core CPI CPINext 5–10 Years Inflation Expectation

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Jan–

07

Sep–

07

May

–08

Jan–

09

Oct

–09

Jun–

10

Feb–

11

Longer-term expectations of inflation (the next five to 10 years) are an important indicator of future inflation trends, as workers seek increased wages in an attempt to adjust to rising price levels.


Investors are also concerned about the inflationary impact of the rise in energy and food prices over the last couple of years. The Federal Reserve is regularly criticized for focusing on core inflation (excluding food and energy), despite its belief and evidence that commodity prices have a weak link to historical headline inflation. In Exhibit 5, we show inflationary periods in the United States over the last 40 years.

Source: Bloomberg, Northern Trust Global Investments. Note: Crude energy and food and Producer Price Index measurements.

High headline inflation in the 1970s and early ’80s was accompanied by high energy and food prices, but also by high unit labor costs. During the last three decades, as the amount of energy the U.S. economy needed to generate a dollar of output fell by just over 50%, the impact on inflation fell. The inflationary impact of surges in energy and food prices during this period was negligible, as contained unit labor costs kept headline inflation in check. We believe this will prove true again this decade.

WON’T NATIONAL BUDGET DEFICITS BOOST RATES?The risk of national deficits pressuring interest rates is a significant concern, as a political solution is required to prevent this outcome. Standard & Poor’s (S&P) recently downgraded the outlook on the AAA rating of U.S. debt, noting the uncertain path toward political agreement on a long-term deficit reduction plan. It is noteworthy that in the wake of the downgrade, equity markets fell but U.S. Treasuries rallied and the 10-year yield dropped from 3.41% to 3.35%. As shown in Exhibit 6, credit default swaps (a measure of default likelihood) for the United States are higher than Norway, Switzerland and Germany, comparable to the United Kingdom, and lower than China or Japan. Fixed income markets are viewing leading global companies such as Nestle, The Coca Cola Company and Wal-Mart Stores, Inc. as being as credit-worthy as the best countries. Without a strong budget outlook, we think that the sovereign debt of some countries, such as the United States, will move from being viewed as risk-free to being viewed as low-risk.

Without a strong budget outlook, we think that the sovereign debt of some countries, such as the United States, will move from being viewed as risk-free to being viewed as low-risk.

Range Crude Energy Crude Food Unit Labor Cost CPI CPI Y+1

9/30/1971 – 8/31/1973 NA 52% 5% 5% 8%

1/31/1978 – 2/28/1981 42% 12% 11% 13% 13%

5/31/1995 – 1/31/1997 39% 10% 1% 3% 2%

6/30/2002 – 5/31/2004 40% 23% 0% 2% 3%

5/31/2006 – 7/31/2008 38% 27% 3% 4% 2%

9/30/2009 – 2/28/2011 22% 31% -1% 2% NA

EXHIBIT 5: LABOR COSTS REQUIRED TO DRIVE INFLATION

Drivers of Inflation


EXHIBIT 6: GLOBAL CORPORATE SOVEREIGNS?

10 Year CDS Levels – Basis Points


Note: Credit default swaps are an instrument for transferring the default risk of a certain security from the buyer of the swap to the seller. If a buyer purchased $1 million in CDS on a 10-year government security with a rate of 300bps, it would pay $30,000 per year for the length of the contract.

The relationship between interest rates and budget deficits is a matter of academic debate, but the historical track record in the United States and United Kingdom does not demonstrate a direct relationship. In the mid-’90s, the Clinton administration faced projections that thefederal debt could be paid off – and Fed Chairman Alan Greenspan worried about the Fed’s ability to conduct monetary policy with no federal debt to buy or sell. At a time where bonds were expected to become an endangered species, a scarcity premium would have been expected to drive down rates. Conversely, our current situation of surging deficits could be expected to lead to higher rates to entice skeptical buyers. However, the interest rate on the 10-year Treasury sits today at under 3.5% compared with just above 5% in the mid-’90s. This is further evidence that, in our view, the outlooks for growth and inflation are the key drivers of interest rates.

EXHIBIT 7: DEFICITS DON’T DRIVE INTEREST RATES

Interest Rates vs. Government Debt – United States

Source: Bloomberg, Haver, Measuring Worth, UKPublicSpending.com, White House, IMF, Northern Trust

Global Investments.

0

300

600

900

1200

1500

Nor

way

Switz

erla

nd

Nes

tle

Coc

a C

ola

Ger

man

y

Wal

mar

t

UK

USA

Siem

ens

Chi

na

Fran

ce GE

Japa

n

Mex

ico

Braz

il

Russ

ia

Irela

nd

Arg

entin

a

Gre

ece

Vene

zuel

a

36 49 53 63 66 72 74 75 89 99 100 112 122 141 157 184

485

640

9951073

0

20

40

60

80

100

120

Debt% of GDP (Left)10 Year %

1954

1958

1962

1970

1974

1978

1982

1986

1990

1994

2010

2006

2002

1998

Exhibit 2: Interest Rates vs. Government Debt


1954

1958

1962

1970

1974

1978

1982

1986

1990

1994

2010

2006

2002

1998

0

20

40

60

80

100

120

-5

0

5

10

15

20

25

-5

0

5

10

15

20

25

1966

1966

The relationship between interest rates and budget deficits is a matter of academic debate, but the historical track record in the United States and United Kingdom does not demonstrate a direct relationship.


EXHIBIT 7: DEFICITS DON’T DRIVE INTEREST RATES (cont’d)

Interest Rates vs. Government Debt – United Kingdom

Source: Bloomberg, Haver, Measuring Worth, UKPublicSpending.com, White House, IMF, Northern Trust Global Investments.

Professors Carmen Reinhart and Kenneth Rogoff 1 have conducted seminal research on the impact of financial crises on government debt levels, asset prices, inflation and growth. Two important conclusions from their research are the retarding impact on growth of high debt levels and the divergent impact on inflation depending on the maturity of the economy. Advanced economies have not experienced an increase in inflation with rising debt levels, while emerging markets have seen a surge. The United States is cited as an exception to the rule, where their research indicates a significant elevation in inflation during those periods where debt exceeded 90% of gross domestic product (GDP). However, in the 216 years of observations, the United States had five years with debt above 90%. The U.S. economy is more self-sufficient than many advanced economy counterparts and the U.S. dollar continues to retain its status as a reserve currency, so we see the risk that the United States may experience a worse-than-average outcome as low.

EXHIBIT 8: DEBT EXPLOSIONS DON’T LEAD TO ADVANCED ECONOMY INFLATION

Government Debt Impact on Inflation

Source: Reinhart and Rogoff, December 2009, Northern Trust Global Investments. Data period from 1946 – 2009.

1. Carmen Reinhart is an economist at the Peterson Institute for International Economics; Kenneth Rogoff is an economics professor at Harvard University.

0

20

40

60

80

100

120


1954

1958

1962

1970

1974

1978

1982

1986

1990

1994

2010

2006

2002

1998



1954

1958

1962

1970

1974

1978

1982

1986

1990

1994

2010

2006

2002

1998

0

20

40

60

80

100

120

-5

0

5

10

15

20

25

-5

0

5

10

15

20

25

1966

1966

The U.S. economy is more self-sufficient than many advanced economy counterparts and the U.S. dollar continues to retain its status as a reserve currency, so we see the risk that the United States may experience a worse-than-average outcome as low.

Inflation rates (%) when government debt as a % of GDP is...

Below 30%

30% to 60%

60% to 90%

90% & above

AdvancedEconomies

Average 6.4 6.3 6.4 5.1

Median 5.2 3.7 3.5 3.9

EmergingMarkets

Average 64.8 39.4 105.9 119.6

Median 6.0 7.5 11.7 16.5

EXHIBIT 8: DEBT EXPLOSIONS DON’T LEAD TO ADVANCED ECONOMY INFLATION

Government Debt Impact on Inflation


WON’T RISING RATES CRUSH FIXED INCOME RETURNS?For the investor who fears the specter of high future interest rates, an example from history may provide a valuable illustration. Yields today are similar to yields in 1953, before the big run-up in interest rates. But surprisingly, the investor who purchased intermediate-term government bonds in 1953 and held them through peak yields in 1981 actually earned a 4.4% compound annual return over the worst period of rising interest rates in modern U.S. history. This return kept pace with inflation (also 4.4% over the 1953-1981 period), enabling bond investors to maintain their purchasing power despite a long period of steeply rising rates powered by inflation. The key point is that bond prices tend to incorporate expectations of rising interest rates, and a portfolio of shorter- and intermediate-term bonds can adjust to unexpected interest rate changes through time.

Additionally, the historical experience with Fed tightening cycles shows that fixed income can also generate positive returns in these environments. First, the markets at the start of the cycles had likely already built some rate increase expectations into intermediate- and longer-term bonds. Second, the coupon return during the hiking cycle helps offset some reduction in the value of the bonds whose interest rates rose. Exhibit 9 shows the annualized return performance of the Barclays Capital U.S. Treasury Index during the last five Fed tightening cycles – all of which were positive.

S

Source: Bloomberg, BarCap Live, Northern Trust Global Investments.Note: The total return is based on the index, Barclays Capital U.S. Treasury Aggregate

Analyzing the interest rate cycles where longer-dated Treasuries hadn’t fully discounted rising interest rates shows five such episodes in the United States over the last three decades where the 10-year Treasury had a jump in yields of more than 1.5%. While the results of this more stressful exercise are not as positive as the study of Fed cycles, the returns average to a loss of about 1.0% – in effect, an insurance premium being paid to provide portfolio stability.

EXHIBIT 9: FED FUNDS HIKES DON’T TANK BOND RETURNS

The key point is that bond prices tend to incorporate expectations of rising interest rates, and a portfolio of shorter- and intermediate-term bonds can adjust to unexpected interest rate changes through time.

RangeStart Point

Cumula-tive Move

Price Return

Coupon Return

Total Return

Annual Return

S&P Annual Return

4/29/1983 – 9/28/1984 8.5% 3.3% – 6.5% 16.2% 9.6% 6.7% 5.4%

11/28/1986 – 6/30/1989 5.9% 3.8% – 4.5% 24.0% 19.5% 7.1% 13.7%

1/31/1994 – 6/30/1995 3.0% 3.0% – 3.8% 9.7% 5.9% 4.2% 12.3%

5/31/1999 – 12/29/2000 4.8% 1.8% 2.3% 10.9% 13.2% 8.1% 2.1%

5/31/2004 – 8/31/2007 1.0% 4.3% – 0.7% 15.8% 15.1% 4.4% 10.8%

Average 4.6% 3.2% – 2.6% 15.3% 12.7% 6.1% 8.8%

EXHIBIT 9: FED FUNDS HIKES DON’T TANK BOND RETURNS

Federal Reserve Tightening Cycles


0%

1%

2%

3%

4%

5%

6%

6m 1yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr1m 3m

3 Year Forward 5 Year ForwardCurrent 1 Year Forward

Source: Bloomberg, BarCap Live, Northern Trust Global Investments.

Note: The total return is based on the index, Barclays Capital U.S. Treasury Aggregate

WHAT IS THE OUTLOOK FOR FIXED INCOME IN THE CURRENT RATE ENVIRONMENT?Let’s now consider forward-looking return potentials, given today’s outlook for interest rates. In Scenario 1, the investor doesn’t worry about the risk of rising rates and buys an 8-year Treasury bond that earns a yield to maturity of 3.15%. In Scenario 2, the investor fears rising interest rates and holds cash for three years before re-entering the market to purchase a 5-year Treasury note at the end of year three. The set of spot and forward (interest rate futures) interest rates that these investors face is displayed in Exhibit 11. The Scenario 2 investor earned the spot rate for cash (1-year Treasury bill) in year one, the 1-year forward rate for cash in year two, the 2-year forward rate for cash in year three, and the 3-year forward yield-to-maturity for the 5-year Treasury in years four through eight. This investor earned a yield to maturity of 3.13% over the eight-year period, comparable to the Scenario 1 investor. From a net present-value perspective, which is the better way to compare different fixed income strategies exposed to changing interest rates through time, the Scenario 1 investor enjoys an even better outcome. Exhibit 11 illustrates the reason.

EXHIBIT 11: MARKETS PRICING IN INTEREST RATE INCREASES OVER 5 YEARS

Future Yield Curve Expectations

Source: Bloomberg, Northern Trust Global Investments. Calculations based on 4/15/2011 prices. For illustrative purposes only.

EXHIBIT 10: 10-YEAR RATE HIKES HARDER TO OVERCOME


RangeStart Point

Cumula-tive Move

Price Return

Coupon Return

Total Return

Annual Return

S&P Annual Return

4/29/1983 – 6/29/1984 10.3% 3.6% – 10.6% 12.5% 1.9% 1.6% –1.5%

8/29/1986 – 9/30/1987 6.9% 2.7% – 11.2% 8.7% – 2.6% – 2.4% 28.7%

9/30/1993 – 11/30/1994 5.4% 2.5% – 11.4% 7.1% – 4.3% –3.7% 1.8%

9/30/1998 – 1/31/2000 4.4% 2.2% – 10.2% 7.8% – 2.4% –1.8% 28.2%

9/30/2002 – 6/30/2006 3.6% 1.5% – 8.9% 16.8% 7.9% 2.0% 14.6%

Average 6.1% 2.5% –10.5% 10.6% 0.1% – 0.9% 14.4%

EXHIBIT 10: 10-YEAR RATE HIKES HARDER TO OVERCOME



It shows that the forward rates for cash indicate that the current bond market expects – and therefore prices in – a rise in short-term interest rates. The market is expecting the 1-year Treasury bill to increase from a current rate of 0.23% to 1.23% in one year to 3.16% in three years. If the Fed does not raise rates as quickly as anticipated (which is our base case), the Scenario 2 investor risks being penalized for holding cash. Furthermore, the forward rate on the 5-year Treasury indicates that the bond market is also pricing in a rise in intermediate-term interest rates from 2.12% to 4.28% in three years, roughly 30 basis points below its average yield from 1926 to 2010. This illustration shows that the current price of bonds reflects expectations of rising interest rates that are reasonable from a historical perspective.

We will be updating our proprietary five-year interest rate forecasts at mid-year, but initial indications are that our forecasts will probably not be higher than the current forward curves – meaning that the Scenario 1 investor would have the better outcome by being fully invested for the eight-year period.

After viewing a long history of interest rates and forward rates in the bond market, we have demonstrated that current bond prices already incorporate expectations of rising interest rates. Therefore, the investor who chooses to wait out a rise in interest rates (the Scenario 2 investor) does not benefit based on current market expectations for intermediate-term yields to rise to near their average historic yield. In the past, rising inflation primarily drove large unexpected increases in interest rates, but inflation expectations remain moderately subdued.

PENSION RISK MANAGEMENT: HEDGING RATE SENSITIVITY OF PENSION LIABILITIESA corporate pension plan’s liability is calculated by discounting future benefit obligations using investment-grade fixed income yields, while public fund liability continues to be calculated using the plan’s expected rate of return. So rising investment-grade interest rates reduce the present value liability of future benefit obligations. In the low-rate environment of the last three years, plan sponsors who believe that rates are more likely to increase than decrease have under-standably chosen fixed income investments having far lower sensitivity to rate increases than the sensitivity of their pension liability. Many corporate pensions have a fixed income benchmark of the Barclays Capital U.S. Aggregate Bond Index, whose duration of 4.9 years means that a 1-percentage-point increase in the yield on this benchmark will equate to a 4.9% decline in the value of securities in this benchmark index. Corporate pension plans have benefit obligations extending for 50 or more years into the future, resulting in liability durations that often range from 10 to 20 years (depending on a variety of factors such as lump sum payment provisions and workforce ages). For a plan with liability duration of 15 years, a 1-percentage-point increase in pension discount rates would result in a 15% decrease in the pension liability. (Conversely, a 1-percentage-point decrease in pension discount rates would result in a 15% increase in pension liabilities.)

Here is a hypothetical example illustrating how rising investment-grade interest rates have a powerful benefit for a corporate pension’s funding ratio ratios (assets divided by liabilities). The example assumes:

■ 30% of assets are allocated to fixed income investments; ■ These fixed income investments have a duration of five years; ■ The pension liability has a duration of 15 years.

We believe fixed income should not be viewed in isolation, but as a component of the total portfolio.


Starting Funding Ratio (Assets/Liabilities) 70% 80% 90%

Starting Assets $700 $800 $900

Fixed Asset Loss: 5% loss on 30% of assets – $10.5 – 12.0 – $13.5

Ending Assets $689.5 $788.0 $886.5

Starting Liability $1,000 $1,000 $1,000

Liability Reduction: 15% of Liability – $150 – $150 – $150

Ending Liability $850 $850 $850

Ending Funding Ratio (%) 81% 93% 104%

The following table illustrates the impact of a 1-percentage-point rate increase for pension plans having funding ratios of 70%, 80% and 90%.

Source: Northern Trust Global Investments. For illustrative purposes only.

During the last three years, strong asset returns and corporate contributions required under federal laws have increased the assets of corporate pension plans, while fluctuating rates have resulted in fluctuating pension liabilities. The net result has been an improvement in pension funding ratios over the last three years. For example, a funding ratio improvement from 79.3% in 2008 to 83.9% in 2010 was found in actuarial and consulting firm Milliman’s annual study (released March 3, 2011) of the 100 U.S. public companies with the largest defined benefit plan assets.

But the preceding table could be modified to show how a 1-percentage-point decrease in pension discount rates would drastically reduce the funding ratio, with smaller asset gains swamped by the far larger increase in pension liabilities (which was seen starting in 2009 after the Fed cut rates and initially wide credit spreads eventually narrowed to more normal levels). Reducing sensitivity of pension liabilities to rate decreases can be accomplished by investing fixed income assets so that asset duration is similar to the 10- to 20-year duration of pension liabilities. If a fully funded pension plan allocates 100% of its assets to investment-grade fixed income securities whose total duration approximates the duration of the liabilities, then a rate decrease results in a pension increase that should be approximately offset by the gain in value of fixed income assets. Note that this is a hedging approach, so an increase in rates results in a decrease in pension liabilities that is offset by a corresponding decrease in the value of pension assets.

If corporate pension asset growth continues, and pension funding ratios continue to improve, the question facing corporate pension sponsors is: “When should the duration of fixed income investments be lengthened to reduce the sensitivity of the pension surplus (or deficit) to interest rates?”

EXHIBIT 12: BENEFIT OF RISING INVESTMENT-GRADE INTEREST RATES

Impact of 1% Rate Increase for Pension Plans


A market timing approach to deciding when to increase the duration of a pension’s fixed income assets might focus on determining when pension discount rates have reached a level where it is as likely that rates will decrease as it is that rates will increase.


1995

1997

1999

2001

2003

2005

2007

2009

2011

4.5%5.0%5.5%6.0%6.5%7.0%7.5%8.0%8.5%

5.14%5.58%5.79%6.01%6.33%6.65%6.87%7.16%7.46%7.83%8.20%

Percentile Discount Rate

EXHIBIT 13: PENSION DISCOUNT RATES

1%10%20%30%40%50%60%70%80%90%99%

The following graph illustrates the 16-plus year history of a representative pension discount rate series.

Source: Citigroup Pension Liability Index, Northern Trust Global Investments.

A MARKET-TIMING APPROACH: WAIT FOR “NORMAL” PENSION DISCOUNT RATESPension discount rates reached a low in 2010. The indicative rate of 5.75% as of March 31, 2011, represents an increase of 75 basis points (bps) and is 90 bps below the median.

So a market timing approach to deciding when to increase the duration of a pension’s fixed income assets might focus on determining when pension discount rates have reached a level where it is as likely that rates will decrease as it is that rates will increase. In the absence of a forward yield curve signaling expected further rate increases (for example, due to expected inflation), a return toward the median discount rate might be a time to estimate the current funding ratio and consider extending the duration of fixed income assets.

AN OBJECTIVE-BASED APPROACH: PROTECT IMPROVED FUNDING RATIOSThe objective of a pension plan is to provide for the payment of future benefit obligations. The earlier example demonstrated that a 1-percentage-point increase in investment-grade rates could improve the funding ratio of a corporate pension plan with a 90% funding ratio to 104%. If rates remain stable and asset returns remain positive, a corporate pension plan’s funding ratio may improve to a level where future rate increases may result in a pension surplus, which may or may not benefit the plan sponsor.

The benefit of growing pension assets beyond the level of pension liabilities varies depending on whether the plan continues to accrue new obligations. For a frozen plan that has stopped accruing obligations, excess assets are not easily used by the corporation for other purposes. So when a corporate pension plan is fully funded, there is little reward for the risk of equity losses or liability increases resulting from rate decreases, because resulting losses in funding ratio are likely to increase pension contributions. The corporate sponsor of such a frozen plan should consider reducing equity risk and pension discount rate risk as the objective of full funding grows nearer.

The following graph illustrates how a corporate pension sponsor can think of its assets as divided into two portfolios serving two different purposes: a “hedging” portfolio seeking to reduce the discount rate sensitivity of pension surplus (or deficit), and a “return” portfolio seeking to generate asset returns in excess of pension discount rates. As the plan’s funding ratio increases (moving from left to right on the horizontal axis), assets are transferred from the return portfolio to the hedging portfolio.


Source: Northern Trust Global Investments

The very small return allocation seen as a 100% funding ratio is achieved might be appropriate for a frozen plan. A plan that continues to accrue pension obligations may choose to keep 50% or more of its assets in the return portfolio. The goal would be to generate returns in excess of the liability growth rate that can help offset new service costs, resulting in lower contributions than with a 100% hedging portfolio. If the remaining allocation to the hedging portfolio is invested with longer duration, this should reduce the sensitivity of pension assets to discount rate changes, reducing the volatility of funding ratio and future contributions when compared with a traditional intermediate-duration fixed income allocation.

This objective-based approach uses asset-liability analysis to develop a forward-looking glide path, with funding ratio targets intended to trigger projected asset allocation changes. As these funding ratio targets are attained, rate sensitivity is reduced by extending the duration of fixed income assets and increasing the proportion of assets allocated to fixed income. The plan’s funding ratio is then regularly estimated to determine when a funding ratio target has been attained and to affirm the asset allocation change, based on a review of the plan’s objectives and the market environment. Additional data and analysis provided by Phil Grant and Joe LaPorta.

Liability Hedging Investments

–Long Credit

–Long Government

–Intermediate Duration

–Strips

EXHIBIT 14: SAMPLE COMPOSITION OF PENSION FUNDS

Sample Pension Risk Glidepath

Return Seeking Investments

–US Equities

–International Equities

–High Yield

–Hedge Funds — FOR ILLUSTRATIVE PURPOSES ONLY —


© northern trust northern trust banks are members fdic equal housing lenders

Q 30829 (5/11)

IMPORTANT INFORMATION: Past performance is no guarantee of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. There are risks involved in investing including possible loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be met. Risk controls and models do not promise any level of performance or guarantee against loss of principal.

This material is directed to eligible counterparties and professional clients only and should not be relied upon by retail investors. The information in this report has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. Opinions expressed are current as of the date appearing in this material only and are subject to change without notice. This report is provided for informational purposes only and does not constitute investment advice or a recommendation of any security or product described herein. Indices and trademarks are the property of their respective owners. All rights reserved.

NOT FDIC INSURED May lose value No bank guarantee

EX

Insights on INFLATION AND FIXED INCOME INVESTMENTS · large debt burdens and the economy’s...

Documents

Transcript of Insights on INFLATION AND FIXED INCOME INVESTMENTS · large debt burdens and the economy’s...