Portfolio design

Steeper yield curve still spells potential opportunity for LDI investors

BlackRock |Aug 16, 2019

The market outlook for LDI investors has shifted dramatically in recent months. With a more dovish Fed and a steeper yield curve at the long end, we think it’s time to consider the potential benefits of long-duration assets.

Over the course of the past decade or so, investors witnessed a dramatic flattening of the yield curve, with the difference between 30-year and 5-year Treasury yields falling to as low as 25 basis points (bps) in September 2018. Relatively similar yields across the curve led many asset-focused investors to reconsider the efficacy of extending the maturity profile of their fixed income portfolios. For asset-liability focused investors, such as corporate defined benefit plans, the market dynamic led to questions around whether the flatter yield curve should also impact LDI positioning.

Recently, while many investors have been focused on the inversion of the yield curve between the front end and the 10-year Treasury, the yield curve between 5-year and 30-year Treasurys has steepened to levels not seen since 2017. In this piece, we explore the market dynamics behind this steepening and explain why we believe it can still be attractive for LDI investors to hedge their liabilities with long duration assets.

A changing yield environment

Falling inflation and inflation expectations have triggered the Fed to increase focus on how it can use monetary policy to stoke inflation toward its target level of two percent. As slowing growth, increasing trade disputes and reduced market liquidity have led the FOMC to move from a tightening bias, to a policy-rate pause, and now to an easing bias, we have seen interest rates and interest-rate expectations fall.

That said, the change in yields has not been parallel. Shorter yields have decreased significantly more than long-end yields, as investors have focused on short rates and Fed policy. As seen in the Getting steeper chart, the spread between 5-year and 30-year Treasuries has increased by 25 bps since the start of 2019, and by 50 bps since June 2018.

Getting steeper

Difference between 5-year and 30-year Treasury yields, June 2017-June 2019

Difference between 5-year and 30-year Treasury yields, June 2017-June 2019

Source: Bloomberg, as of June 30, 2019. Past performance is not indicative of future results.

While rates are lower than earlier this year, there are a few reasons it may be prudent for plans to move forward with increasing liability hedges.

Carry

With the steepening Treasury curve, as well as the fact that short Treasury rates are inverted at some maturities, investors benefit from greater carry at the long end of the curve. At the long end, the steeper curve also contributes to higher initial carry where levered hedging instruments have a financing rate (short-rate) lower than the fixed rate (long-rate) received.

Defensiveness: The benefits of duration

Given market uncertainty due to inflation concerns, central bank policy, and global trade conflicts, many asset-only investors can start to think about adding long government bonds to build portfolio resilience. For LDI investors though, the potential benefits of government bonds are even more critical. In our experience, most LDI investors are effectively short duration versus their liability, and adding long-maturity exposure can allow for more efficient use of capital and can reduce expected funded-ratio volatility. This potential risk mitigation should be an important concern for plan sponsors to consider, particularly those looking to diversify equity risk. While the flatter curve witnessed through late 2018 led some plans to consider utilizing shorter-duration fixed income to earn comparable yield, this would reduce the level of risk mitigation if rates were to fall.

In the Shock absorber exhibit below, we illustrate the potential impact of utilizing two similar portfolios to hedge a sample liability. The first portfolio is a generic 50% growth/50% fixed income portfolio. The second portfolio has the same weights, but utilizes a custom rates overlay to more efficiently hedge the liability. Here, both the sheer duration achieved with capital-efficient instruments, as well as the focus on the back end of the curve, where most liability duration is present, seeks to limit funded status downside in both risk-on and risk-off scenarios.

Shock absorber

Hypothetical impact to surplus of 100% funded plan (assets vs liability) in risk-off and risk-on scenarios

Shock absorber

Source: BlackRock, as of 7/11/2019. ‘50/50 Portfolio’ modeled as 50% Growth and 50% Fixed Income. The growth portion consists of the Russell 1000 Index, the MSCI World ex US Index, the MSCI ACWI Index, S&P Listed Private Equity Index, and the Dow Jones U.S Real Estate Total Return Index The fixed income portion consists of the BBG Barc U.S. Long Government/Credit Index and the BBG Barc T-Bill 1-3 Month Index. ‘50/50 Portfolio w/ Rates Overlay’ modeled as 50% Growth and 50% Fixed Income, The growth portion consists of the Russell 1000 Index, the MSCI World ex US Index, the MSCI ACWI Index, S&P Listed Private Equity Index, and the Dow Jones U.S Real Estate Total Return Index The fixed income portion consists of BBG Barc US Long Credit Index, ICE Levered STRIPS Indices, and the BBG Barc T-Bill 1-3 Month Index. Expected stress P&Ls are calculated using BlackRock Portfolio Risk Tools using the trailing 180 months of equal-weighted observations as of 7/11/2019. Each component is mapped to a broad set of risk factors; the parametric exposures to changes in key interest rates, spreads, and other risk factors are calculated for each component. The parametric exposures are then summed using the appropriate weights to compute the total exposure to systematic market risk factors. BlackRock’s parametric return model then uses the risk factor changes and exposures in the specified scenario to estimate the total return. No representation is made as to the accuracy or completeness of the scenario analysis shown on this page or the validity of the underlying methodology and are provided for informational purposes only. The scenario analysis should not be misinterpreted as constituting the actual performance of any portfolio nor should they be relied upon in connection with any investment decision relating to any BlackRock strategy or fund. All investments involve a risk of loss of capital, and no guarantee or representation can be made that an investment will generate profits or will avoid losses. Past performance is not a guarantee of future results.

Global Rates

U.S. rates are still significantly higher than those of other developed nations, especially at the back end of the yield curve, with 30-year rates in countries such as France, Germany, Japan and Switzerland below 0.90%. See the Developed market winner chart below. With the low global rate environment, there may be less impetus for sharp rises in long rates in the U.S. On the fundamental side, the curve has flattened as a consequence of geopolitical issues outside of the US (Italy, Argentina, Hong Kong, Brexit, European growth) driving a flight to safety. Meanwhile, the US economy remains in a healthy position.

Developed market winner

30-year government bond yields

30-year government bond yields

Source: Bloomberg, as of August 14. Past performance is not indicative of future results.

Looking ahead

Given the structure of the yield curve, we believe there is a strong incentive for plans to stay aligned with their strategic hedging goals and to further improve their liability awareness. Whether a plan is in the early stage of its de-risking cycle, or is further along and looking to add precision to its liability-matching strategy, interest-rate hedging using long durations assets may help reduce funded-status volatility. In the current environment, long duration fixed income may be a key lever for de-risking corporate defined benefit plans.