Views from the LDI desk: Summer 2024 markets commentary

As outlined in our spring 2024 markets commentary, tight spreads and high Treasury rates presented an opportune time to hedge more interest rate risk. Recently, market expectations have swung significantly, after softening employment data began to worry investors. As a result, market pricing for rate cuts through the December 2024 Federal Open Market Committee (FOMC) dramatically increased from just over two cuts priced in earlier this summer to as much as five¹, before moderating.

With the fall in rates from recent peak levels, this begs the question for Liability-Driven Investing (LDI) clients: is it still an opportune time to hedge more liability rate risk? In general, this should be a strategic view and typically one that mitigates funded status risk. However, in our view, there are four key reasons in the current market environment that continue to support, and possibly even bolster, the case for more hedging.

1. Overall yields

10-year Treasury yields are now well off the recent peaks achieved in the end of April 2024², but context is important. Fact patterns have changed since that time, with a number of data points supporting the notion that inflation is steadily cooling and labor market growth is beginning to moderate. Given these outcomes, Treasury rates are understandably lower, as the market braces for a potential inflection point in the Fed’s short-term rate policy. This said, rates are still high by recent historical standards, including real yields (yield after implied inflation), which remain between 1.5% to 2.25% across the 5 to 30-year parts of the yield curve³.

2. Relative to credit

Many plans have limited capital in fixed income and must decide how best to use that capital to support hedge exposures. This includes a decision on the relative magnitude of rates vs. spread hedging of the liability discount rate. Strategic considerations such as liability duration and growth asset composition should generally steer this decision. This said, it can often be the case that increasing a rate hedge, while reducing credit spread exposure, will reduce funded status risk⁴. The context of today’s market environment may support that direction of travel. Credit spreads have generally become a far smaller proportion of liability discount rates, which could mean that rates are the more prevalent risk for LDI investors to hedge. As shown in the chart below, it has actually been close to two decades since corporate spreads were as small a proportion of overall liability discount rates.

^{Source: Bloomberg, BlackRock as of December 31, 2023. Liability discount rate components were calculated by taking the Yield to Worst – the OAS of the Bloomberg Barclays Long Corporate AA Index. Spread component was modeled as the OAS.}

3. Short-term rates (implied financing in derivatives)

One of the key ways LDI investors attain their rate hedging exposures, with limited fixed income capital, is through the use of overlays. Derivatives such as Treasury futures, typically give an investor bond exposure and yield, with an implied short-term financing rate. We’ve been in a historically anomalous time recently, with short-term interest rates higher than long-term interest rates, which has presented a slight headwind to levered exposures. This said, the yield curve has steepened this year and the market expectation is for short-term rates to fall. Should the yield curve continue to steepen and short-term rates continue to fall, this could present a tailwind for derivative exposures in lower implied financing costs, and higher net yields.

4. Diversification

Market focus has shifted from inflation to growth, and recent stock bond correlation has turned negative as a result. Over the course of the recent equity selloff, we saw a sharp rally in bonds, a welcome sign that bonds may be back as a portfolio diversifier. Still, while yields are not as high as they were earlier this year, bonds can serve multiple purposes in a portfolio again and remain a key portfolio hedge in the event a recession materializes.

^{Source: Bloomberg, BlackRock as of August 5, 2024. Past performance is not a guarantee of future results. Nasdaq as represented by NDX Index, Russell 2000 as represented by RTY Index, S&P 500 as represented by SPX Index, Japan Equity as represented by NKY Index, Gold as represented by GOLD Index, Long Duration Treasury as represented by ICE US Treasury 20+ Year Bond Index, Equal Wtd Equity as represented by SPW Index, Crude Oil as represented by Bloomberg WTI Crude Oil Subindex Total Return Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index.}

With corporate DB plan funded ratios still near multi-year highs⁵, the goals of protecting surplus and diversifying risks remain prominent for plan sponsors.

Bringing it all together

Fixed income markets have evolved significantly over the past few years, and market consensus is growing that an inflection point is nearing. While pockets of uncertainty remain with respect to government debt levels and yield curve shape, we believe it is important for LDI investors to take the factors mentioned above into consideration, in pursuit of effective portfolio positioning and risk management.