Views from the LDI desk: LDI in a rising rate environment

Feb 26, 2021
  • BlackRock

We saw yet another local high in 10-year Treasury yields last week, briefly touching above 1.60% intraday Thursday after a weak 7-year auction led to an immediate 10+ basis point selloff. This was the new largest single-day selloff since mid-March 2020, and even with a modest reversal, the 10-year and 30-year yield levels stand near their highest in the past 12 months.1

Fed officials have so far not deviated from their stated comfort level regarding the move higher in yields, with Fed president Bostic reiterating the message even after the auction results.2

Corporate pension response

Last week saw elevated inbound inquiry and flow into long duration assets as rising rates catalyzed substantial funded ratio improvements; as seen in the chart below, by our estimates a typical plan’s funded status may have now increased approximately 3% year-to-date as of 2/26/21, and approximately 8% since the start of the fourth quarter 2020.

Estimated U.S. pension funded pension status ratio vs 30 year U.S. treasury yield

Estimated U.S. Pension Funded Status Ratio vs 30 year U.S. treasury yield

Source: BlackRock, BofA Merrill Lynch. Past performance is not indicative of future results. Time series starting on 12/31/2018. Estimated Pension Funded Status is based on the average asset allocation of the US corporate defined benefit plans for which Pensions & Investments includes an asset allocation breakdown as of 9/30/2018. This asset allocation is as follows: 47.0% weight to Barclays Long Government/Credit Bond Index, 21.0% weight to Russell 1000 Index, 12.0% weight to MSCI World ex US Index, 5.0% weight to MSCI ACWI Index, 6.0% weight to S&P Listed Private Equity Index, 5.0% weight to Dow Jones U.S. Real Estate Index, 2.0% weight to Barclays 1-3 Month T-Bill Index. Based on the aforementioned indices, YTD as of 2/26/2021, the assets have returned -2.15%, and the liabilities have returned -5.18% resulting in a funded ratio increase of 2.82%. Based on the aforementioned indices, as of 9/30/2020, the assets have returned 5.95% and the liabilities have returned -3.33%, resulting in a funded ratio increase of 7.97%. No allowance has been made for active management or costs. Asset returns are based on the historical levels of the aforementioned modelled indices. Liability returns are based on the historical levels of the Bank of America Merrill Lynch Mature US Pension Plan AAA-A Index. The assumed funded ratio is sourced from the Milliman Corporate Funding Study on the 100 largest US corporate defined benefit pension plan sponsors as of 12/31/2020.

Flows found their way into government and credit sectors, the following is our views and analysis based on BlackRock clients:

  • Plans that have been historically light on credit have added in order to meet new capital and/or spread hedge ratio targets at new glide path steps, sourcing from both return-seeking assets as well as existing government holdings.
  • Plans with dollar-for-dollar liability matched portfolios, generally allocated pro-rata into duration-neutral credit and government holdings.
  • Plans with higher rate hedge ratio targets and/or key-rate matching needs utilized capital efficient rate derivatives.

Where do things go from here?

We saw support at the long-end of the Treasury curve amidst last Thursday’s selloff. Last week, the back-end of the Treasury curve outperformed the short-end as we believe investors sought to satisfy pent up de-risking needs.3 Insurance buyers were also active this week, likely taking advantage of higher yields. We suspect this long-end institutional demand will persist over the near term.

Nuances in supply and demand, liquidity and transaction costs have been increasingly prevalent in Treasury and credit markets. Prior to trading, we encourage discussion, where possible, with a BlackRock relationship manager to evaluate market opportunities and de-risking considerations.

We believe the question on many investors’ minds right now is if and when the Fed will step in to provide further market support. While a possibility, we believe the rise in rates would have to begin to constrain the flow of credit to the real economy, which it does not appear to have. As we will discuss in more detail in our soon to be released Corporate Pension Themes, even in the face of rising rates, gains in funded status should continue to support allocations to long duration assets.

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