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Fixed Income

Pension Curve Insider: LDI Solutions March Monthly Recap

Aaron Stonacek, ASA, CFA, Solutions Analyst
Justin Harvey, Solutions Strategist for Multi-Asset Solutions

Monthly Recap

Discount rates jumped again in February as yields adjust to fiscal and monetary policy coming out of Washington. The AA-rated spot curve moved up 20 basis points while the top-yielding curve rose 15 basis points. Spreads reversed trend in February, widening across all IG qualities while Treasury yields rose across all tenors. February saw a nearly-uniform increase across the yield curve, with most tenors rising between 13-20 basis points from last month.

Spreads across investment-grade qualities widened modestly during the month, with AA’s moving the most. After the jump in February, discount rates now sit about level to this time a year ago, using the broad AA discount rate curve. Top yielding AA-rated bonds are now just 12 basis points lower than February 2017, and provide 22 basis points of additional yield relative to the broader market.

February saw minimal index turnover in the AA-rated index as only about 1% of index market value changed hands. New issues accounted for most of the turnover, with nearly $6B in market value entering the index across a wide range of maturities. The largest new issues impacted the front-end of the curve, as about 75% of new entries occurred between the 3-5 year tenors. Exxon Mobil made up February’s only exiting bond, with a 2018-maturity issue leaving the index during the month.

Liability Impact

Yield Curve

Liability Value
2/28/18

Discount Rate
2/28/18

Liability Value
1/31/18

Discount Rate
1/31/18

Liability Value
12/31/17

Discount Rate
12/31/17

Accounting
Yield Curve

$9,901

4.08%

$10,173

3.88%

$10,386

3.73%

Top Yielding
Accounting Curve

$9,610

4.30%

$9,805

4.15%

$9,994

4.01%

IRS Yield Curve

$9,828

4.11%

$10,178

3.86%

$10,283

3.76%

Sources: Barclays POINT, IRS, and T. Rowe Price. Sample plan cash flows have a liability of $10,000 at 4.0% discount rate.

Accounting Curve

Sources: Barclays POINT and T. Rowe Price

Issuer

Event

Curve Impact

Province of Ontario

New Issue

(1 bond)

Province of Ontario issued a short-maturity bond last month that made up over half of the month’s new entries into the AA-rated index. The 2021-maturity bond adds about $3.0B to the index market cap. Due to the large amount of issues at the short end of the curve, Ontario’s issue only moved the AA-rated curve 1 basis point at the 3 year mark.

United Airlines

New Issue

(1 bond)

United Airlines issued a $670M bond maturing in 2030 in February. While the issue only accounted for about 10% of the new market value entering the index, it’s impact on the yield curve was more pronounced given the limited number of issues at the 12-year mark. Overall, the United Airlines issue caused a reduction of 17 basis points at that tenor.

Sources: Barclays POINT and T. Rowe Price

 

New Issues

Other Bonds Entering

Downgrades

Other Bonds Exiting

February 2018

Count

4

1

0

1

Market Value ($M)

$5,485

$339

$0

$1,000

Market Value (%)

0.86%

0.05%

0.00%

0.16%

 
2018 YTD

Count

18

1

0

5

Market Value ($M)

$18,365

$339

$0

$5,790

Market Value (%)

2.87%

0.05%

0.00%

0.90%

Sources: Barclays POINT and T. Rowe Price

Top Yielding Accounting Curve

Sources: Barclays POINT and T. Rowe Price

IRS Curve

Sources: IRS and T. Rowe Price

Dates

AAA Corporate OAS

AA Corporate OAS

A Corporate
OAS

January Monthly Average

40

46

70

February 1, 2018

38

45

67

February 15, 2018

40

50

74

February 28, 2018

44

54

77

February Monthly Average

41

50

73

Sources: Barclays POINT and T. Rowe Price

One-year Rolling Returns and Tracking Error

 

February 2018 Return

YTD Total
Return

Annual Tracking Error Relative to Liability

Average Monthly
Return Difference from Liability

Hypothetical Sample Plan Liability

-2.37%

-4.10%

NA

NA

BBgBarc Aggregate

-0.95%

-2.09%

6.64%

1.46%

BBgBarc Long Credit

-3.31%

-4.55%

4.60%

0.93%

BBgBarc Long Gov/Credit

-3.15%

-5.15%

3.22%

0.67%

Hypothetical T. Rowe Price Custom Benchmark

-2.35%

-4.42%

2.09%

0.33%

Sources: Bloomberg Index Services Ltd., T. Rowe Price; Analysis by T. Rowe Price. Performance shown in graph and tables above shown from February 1, 2005 through February 28, 2018.

Past performance cannot guarantee future results. Custom Benchmark returns do not reflect the deduction of management fees. Please refer to the disclosure at the end of the article for important additional information.

Copyright 2018, Bloomberg Index Services Ltd. Used with permission.

Glossary

IRS Yield Curve: Plan sponsors of qualified defined benefit pension plans use this yield curve to determine funding requirements per IRS regulations. These funding requirements are disclosed on form 5500 annually. Yields on AAA, AA, and A corporate securities determine the yield curve for discounting purposes. The yield curve is not a marked-to-market curve representing any single date, but rather an average yield over the course of the entire month. For more information on the IRS methodology, please see treasury.gov/resource-center and irs.gov/Retirement-Plans.

Accounting Yield Curve: US GAAP requires pension plan sponsors to disclose pension obligations using “fixed-income debt securities that receive one of the two highest ratings given by a recognized ratings agency”. As a proxy for bonds useable for accounting purposes, we use the constituents of BBgBarc AA credit universe to develop the accounting yield curve shown. Please see fasb.org for more information.

Top Yielding Curve: Since the US GAAP rules allow the use of a fairly broad range of securities for accounting purposes, some plan sponsors use an optimized yield curve approach to value their pension liabilities on the disclosure dates. Bonds trading at higher yields than other bonds of similar maturity tend to be used for this purpose. To quantify the effectiveness of this approach, T. Rowe Price developed a yield curve using the highest yielding bonds designed to meet SEC requirements at each node.

Annual Tracking Error Relative to Liability: Calculated as the standard deviation of return differences between a fixed income index and a set of cash flows discounted using the accounting yield curve. The liability return has two components: an interest cost component analogous to roll return on a bond, and yield change component analogous to price return on a bond. The table shows annualized ex-post tracking error.

Average Monthly Return Difference: Similar to the tracking error metric, this metric demonstrates how closely a fixed income benchmark tracks a set of liability returns. We calculate this measure by simply averaging the difference in returns over the period shown.

Sample Plan Liability: Pension plan sponsors must account for the cost of their retirement plan on their financial statements. The amount of this liability can fluctuate over time based on several factors, including benefits earned, benefits paid out, mortality experience, and most significantly, interest rates. The Sample Plan is intended to be a representative defined benefit pension plan and does not reflect the cash flows from any specific plan.

T. Rowe Price Custom Benchmark: An index of fixed income securities created using T. Rowe Price proprietary methodology that attempts to replicate interest rate exposures embedded in a pension plan’s liability structure.

To learn more, please visit troweprice.com

Important Information

This material is directed at institutional investors or advisors/consultants to institutional investors only and is not intended for distribution to retail investors. It has been prepared by T. Rowe Price Associates, Inc. for informational purposes and is not intended to be investment advice or a recommendation to take any particular investment action. This material should not be redistributed, in whole or in part, without prior consent from T. Rowe Price. The views and information contained herein are as of 28 February 2018 and are subject to change without notice.

The illustrations presented are hypothetical and used to demonstrate capabilities. Certain assumptions have been made for modeling purposes and with the benefit of hindsight and are unlikely to be realized. The specific issuers and bond issues mentioned in this document had significant impact on liability curves calculated using BBgBarc index universes. The modeling used for plan and benchmark development has certain inherent limitations. Benchmark construction may not reflect all material economic and market factors that could have impacted implementation or weighting decisions if the modeled plan actually existed during the time period presented. Actual T. Rowe Price Custom Benchmark characteristics, including (among other things) yield, annualized return, liability-relative tracking error and average monthly returns difference relative to plan liability may differ substantially from the hypothetical scenario presented.

T.ROWE PRICE, INVEST WITH CONFIDENCE and the bighorn sheep design are collectively and/or apart, trademarks of T. Rowe Price Group, Inc. © 2018 T. Rowe Price. All rights reserved.

201803-446047

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