The Markets November 5, 2013

No Need to Flee Fixed Income as Interest Rates Rise

There has been much discussion about moving away from fixed income investments as a response to rising interest rates, but this may not be necessary, a study suggests.
Reported by

Research from Highland Capital Management indicates retirement plan sponsors may consider more shifts within their fixed-income portfolio, from fixed-rate to floating-rate assets.

Bank loans are a part of the capital markets most people refer to as leveraged finance, which includes both high-yield bonds and bank loans. Mark Okada, chief investment officer at Highland Capital Management in Dallas, Texas, told PLANADVISER pension plans have been involved in the leveraged loan space for a long time, but we are hearing about them more now because of what is happening with interest rates. “For the last 20 years, interest rates have almost only come down, but now that is changing,” he said.

Want the latest retirement plan adviser news and insights? Sign up for PLANADVISER newsletters.

Bank loans do not have any interest rate risk, since they are floating-rate assets, Okada added. “The study shows bank loans did not hurt fixed-income portfolios in periods of falling interest rates, but in periods where rates actually rose, it was dramatic how bank loans actually helped,” he said.

Highland Capital conducted an in-depth study of bank loans in a broadly diversified portfolio by testing two specific asset allocation models—a 100% fixed-income portfolio and a 60/40 equity/fixed-income portfolio. According to the study, over the past 20 years, 10-year Treasuries have gradually declined by approximately 400 basis points (6.69%, January 1992 to 2.58%, July 2013) to hit the recent all-time lows. “With fixed income asset classes, one would have expected declining interest rates to favor high-yield and investment-grade bonds. Instead, bank loans did not meaningfully impact from the risk and return of the 60/40 equity/fixed-income portfolio; it also added meaningful value to the 100% fixed-income portfolio,” the study said.

The study explained that bank loans that have a high historical correlation with high-yield bonds; however, bank loans are significantly less correlated with equity and investment-grade bonds. Lower correlations typically mean that a portfolio with bank loans will experience greater diversification benefit (e.g., reduced volatility) than a similar portfolio without bank loans.

Bank loans are also less volatile than high-yield bonds for several reasons. Relative to high-yield bonds, they are more senior in the capital structure, experience lower defaults and have higher recoveries. Also, 58% of outstanding institutional bank loans are currently owned by Collateralized Loan Obligations (CLOs).

Highland Capital performed the same optimal allocation testing on both portfolios for rising rate periods to understand their performance and gain some insights into how the portfolios would hold over the next 20 years. It found the optimal portfolio allocated nearly 100% of the fixed income to bank loans. Generally, the more bank loans investors had in their portfolios during the rising rate periods, the better the performance of their portfolios.

“Over the next 20 years, rates are going back up. Pension plan sponsors are long-term investors, so analyzing the horizon, this will hurt them a lot going forward,” Okada said. “In periods of rising interest rates, bank loans are positive to both types of portfolios, and that is the environment we are entering now, so the investments should be considered.”

Okada added, “Bank loans are gaining a lot of tractions with investors. We are having increasing dialogues in the space, and we expect more activity as interest rates rise.”

The study report, “Bank Loans: A 20 Year Retrospective,” can be found at  https://www.hcmlp.com/News-and-Views/Whitepapers.

Products November 5, 2013

Managing Frozen Pensions No Easy Task

Frozen pension plans are substantially different from open plans and need to be managed accordingly to prevent litigation and ensure positive outcomes for plan participants.
Reported by

Issues in frozen defined benefit (DB) plan management comprise the subject of “The Investment and Management of Frozen Pension Plans,” a handbook published by Russell Investments. 

The handbook examines why more than 8,000—or about a third of all corporate pension plans in the U.S.—have barred the addition of new beneficiaries, and how managers within those plans can better meet fiduciary duties.

Want the latest retirement plan adviser news and insights? Sign up for PLANADVISER newsletters.

Bob Collie, chief research strategist at Russell Investments and one of the handbook’s three authors, said those responsible for the management of frozen plans should base their decisions “not just on what the plan is like today, but on what it will be like in two or five years or further in the future.”

“Funding needs to be built up; investment risk needs to be managed down; governance structures need to be simplified,” Collie said. “The early stages of the path are well trodden, but the later stages are not.”

Bruce Clarke, managing director of client services for Russell Investments, said the process of managing a frozen pension plan is different from an open plan because as plan demographics change—i.e. as average participant age climbs—there is less funding flexibility and greater risk of trapped capital.

“We see more and more frozen plans considering investment outsourcing, and in some more advanced cases the complete transfer of risk through the payment of lump sums or the purchase of annuities,” Clarke said.

Handbook authors divided the guide into three sections exploring pension funding policy, investment policy and risk transfer.

Specific subjects tackled in the handbook include the following:

 

  • Impacts of demography of frozen pension plans
  • The effects of freezing on funding policy flexibility
  • The change in what it means for a frozen plan to be “fully funded”
  • Issues of “trapped capital” and liability-responsive asset allocation
  • The need to define a “final endgame” for the frozen plan.

 

Pension plan sponsors and advisers can request a copy of handbook here.

«