Most pension plans have long-dated liabilities and much shorter-dated assets. In effect, their structure replicates the classic buy-short-sell-long trade: a trade which amounts to a bet on rising interest rates.
The scale of that bet can be illustrated by looking at how the pension deficit has grown in the past four years at some of America’s largest corporations – we call them the $20 billion club¹. At the end of financial year 2008, the 19 club members had a combined pension deficit on their balance sheets of $136 billion. In the ensuing four years, those corporations made cash contributions of $100 billion; that’s $48 billion more than the value of the new benefits that accrued. The plans earned double-digit returns on their investments; investment returns exceeded the interest cost on liabilities by $108 billion. Yet still the pension deficit rose by $84 billion to $220 billion. That happened because of interest rates. The falling rates of recent years have cost pension plans dearly.
Today, faced with the expectation of a rising rate environment, many corporate pension plans are holding off on fully committing to LDI. The bet on rising rates remains enormous.
But it may well be a bet with the odds stacked against it. In part, that is because it is not enough rates rise for the bet to pay off: there is a break-even hurdle to overcome before the position makes a gain. That hurdle is captured in the forward curve.
As shown in the chart below – which is taken from Russell’s monthly LDI update – the forward curve is currently pricing in substantial increases in rates over the next few years: around 1.2% over the next three years on the 10-year rate, for example, and over 2% for the 2-year. Rates would need to rise to levels above each of these break-even forward curves for the bet on rising rates to pay off.
Forward curves – future changes in yield curves implied by current swap prices as of September 30, 2013
Source: Barclays Capital
Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.
What’s more, investment theory and historical experience point to the existence of a term premium, which would make a bet on rising rates even less likely to succeed.
The term premium refers to market pricing tending to favor the holders of long bonds over short, a reflection of the risk preferences of investors in aggregate. That’s why over the past twenty-three years, the forward curve has built in an increase in rates almost 90% of the time—even though that was a period when rates actually fell significantly. A term premium means that a bet on rising rates can be expected to make a loss more often than not, even in an environment where rates are expected to rise.
So the pay-off to a bet on rising rates is negative unless the forward curve break-even point is reached. Of course, rates can, and sometimes do, rise quickly. But a bet on rising rates is one that has historically had the odds stacked against it and investors ought to be wary before assuming that a rising rate environment means easy gains.
¹The $20 billion club consists of the 19 U.S. listed corporations with more than $20 billion of worldwide pension liabilities as of financial year 2011.