To assist plan sponsors with managing interest rate and credit spread risk, in Exhibit 2, we track our estimate of the discrepancy between the actual Libor interest rate swap curve and our fair value assessment of the Libor interest rate swap curve. When the grey line is at zero, interest rates are estimated to be at fair value. With the line below zero, interest rates, in our view, are low. Interest rates moved away from our estimate of fair value during the quarter, as rates decreased. We expect interest rates to rise in the long-run, as they move toward equilibrium levels.
Exhibit 2: Corporate bond spreads and Libor swap curve relative to our assessment of fair values
Changes in the spread between the corporate bond-based discount curve and the Libor interest rate swap curve cause changes in the pension liability discount rate, which in turn causes changes in the liabilities’ present value. We refer to this as liability credit spread risk. Whereas managing interest rate risk via swaps and/or Treasuries is relatively straightforward, managing credit spread risk is more challenging for three reasons:
- Liability credit is not investable: Corporate bonds are subject to default and downgrade risk while liability returns are not.
- There is no capital-efficient risk management tool: We view synthetic exposure to the Credit Default Index (CDX) as an imperfect hedge of liability credit risk.
- Connection to risky assets: During periods of economic stress, equities and other risky return generation assets fall and credit spreads widen. Therefore, the credit profile of the return generation component of a liability-driven investment (LDI) solution needs to be taken into account when constructing the credit profile of the liability hedge.
When the outlook for credit is positive, we seek to hold some credit instruments in the liability hedging portfolio. The green line in Exhibit 2 represents our estimate of the discrepancy between the actual corporate bond discount spread and our fair value assessment of the corporate bond discount spread. When the line is at zero, discount rate spreads are estimated to be at fair value. When it is above zero, credit spreads, in our view, are wide. Discount rate spreads slightly moved farther away from fair value during the second quarter as credit spreads widened by a small margin. We still find credit to be somewhat attractive, although discount rate spreads are not substantially away from fair value.
Funding ratios measure a pension fund’s ability to meet future payout obligations to plan participants. The main factors impacting the funding ratio of a typical US defined benefit plan are equity market returns, which grow (or shrink) the asset pool from which plan participants’ benefits are paid, and liability returns, which move inversely to interest rates.
Liability indices: Methodology
The iBoxx US Pension Liability Index – Aggregate mimics the overall performance of a model defined benefit plan in the US, taking into consideration the passage of time and changes in the term structure of interest rates. The index is based on actual liability profiles, and mimics the investment grade yield curve. It is therefore more appropriate than most existing indices for measuring the performance of defined benefit plans. This index (along with its related active member and retired member indices) is published daily, using the LIBOR interest rate swap curve as the discount curve, a highly liquid universe. This provides the flexibility to use combinations of the indices in order to accurately represent customized liability profiles based on a plan’s specific participant population.
Pension Protection Act (PPA) liability returns are approximated by the Barclays Capital US Long Credit A-AAA Index. This index broadly reflects the duration and credit characteristics of the PPA discount curve that is used to discount expected pension benefit payments for US defined benefit pension plans.
Asset index: Methodology
UBS Global Asset Management approximates the return for the ”typical” US defined benefit plan using the reported asset allocation of the corporate plan subset of the Pension & Investments 1000. The series is constructed using the reported asset allocation weightings and publicly available benchmark information, with geometrically linked monthly total returns.
Pension Fund Fitness Tracker: Methodology
The US Pension Funds Fitness Tracker is the ratio of the asset index over the liability index. Assuming all other factors remain constant, it combines asset and liability returns and measures the impact of a “typical” investment strategy on the funding ratio of a model defined benefit plan in the US due to interest rollup, change in interest rates and typical asset performance, but excludes unique plan factors, such as contributions and benefit payments.