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Fixed Income

Pension Curve Insider

LDI Solutions February Monthly Recap

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

Monthly Recap

Discount rates started 2018 with a jump in January. The AA-rated spot curve moved up 15 basis points as the top-yielding curve moved in tandem, rising 14 basis points from year-end. Spreads tightened for the second consecutive month, albeit modestly, and Treasury yields rose across all tenors. In a reversal from recent months, we saw steepening of the yield curve in January, as the middle and long end rose much more significantly than short tenors.

Spreads across investment-grade qualities contracted modestly during the month, continuing a trend that persisted in much of 2017. Discount rates sit 31 basis points lower than a year ago, using the broad AA discount rate curve. Top yielding AA-rated bonds are 36 basis points lower than January 2017, providing almost 30 basis points of additional yield relative to the broader market.

January saw a pickup in index turnover as new issues accounted for 2% of the AA-rated index market value. Short-maturity bonds dominated new issues during the month, with about $10B impacting the 0-5 year segment. Wells Fargo issued January’s largest bonds netting $4.2B and maturing in 2020 and 2021. Exiting bonds in January amounted to only $4.8B, or 0.75% of the AA-rated index. Walmart made up the majority of the month’s exits, as a total of $2.3B in bonds exited due to upcoming issuer call options.

Liability Impact

Yield Curve

Liability Value 1/31/18

Discount Rate 1/31/18

Liability Value 12/31/17

Discount Rate 12/31/17

Liability Value 1/31/17

Discount Rate 1/31/17

Accounting
Yield Curve

$10,173

3.88%

$10,386

3.73%

$9,749

4.19%

Top Yielding
Accounting Curve

$9,805

4.15%

$9,994

4.01%

$9,343

4.51%

IRS Yield Curve

$10,178

3.86%

$10,283

3.76%

$9,699

4.21%

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

Wells Fargo

New Issue

(2 bonds)

Wells Fargo issued two short-maturity bonds in January that made up about a third of the month’s new entries into the AA-rated index. The 2020-maturity bond is $1.7B while the 2021 issue adds $2.5B in market cap. Together, the two bonds increased the yield curve at the 3-year mark by 4 basis points.

Multiple

New Issue

(2 bonds)

Stanford Healthcare and Sales Tax Securitization Corp. each issued bonds maturing in 2048 during January. While the total market value only netted $800M, the impact on the AA-rated curve was more significant. Yields fell 13 basis points at the 30-year mark as there are fewer securities in the index at longer maturities.
Walmart

Upcoming Call Options

(2 bonds)

Two Walmart bonds left the AA-rated index during January due to upcoming call options. The two issues accounted for about half of the month’s exiting bonds in terms of market cap, at a total of $2.3B. Maturities were at 2023 and 2043, moving the 5 and 25-year marks on the yield curve 4 and 2 basis points, respectively.

Sources: Barclays POINT and T. Rowe Price

 

New Issues

Other Bonds Entering

Downgrades

Other Bonds Exiting

January 2018

Count

14

0

0

4

Market Value ($M)

$12,881

$0

$0

$4,790

Market Value (%)

2.00%

0.00%

0.00%

0.75%

 
2017 YTD

Count

14

0

0

4

Market Value ($M)

$12,881

$0

$0

$4,790

Market Value (%)

2.00%

0.00%

0.00%

0.75%

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

December Monthly Average

42

48

73

January 2, 2017

41

48

72

January 15, 2017

39

45

71

January 31, 2017

39

45

67

January Monthly Average

40

46

70

Sources: Barclays POINT and T. Rowe Price

One-year Rolling Returns and Tracking Error

 

January 2018 Return

YTD Total
Return

Annual Tracking Error Relative to Liability

Average Monthly
Return Difference from Liability

Hypothetical Sample Plan Liability

-1.77%

-1.77%

NA

NA

BBgBarc Aggregate

-1.15%

-1.15%

6.65%

1.46%

BBgBarc Long Credit

-1.28%

-1.28%

4.61%

0.93%

BBgBarc Long Gov/Credit

-2.05%

-2.05%

3.22%

0.67%

Hypothetical T. Rowe Price Custom Benchmark

-2.12%

-2.12%

2.10%

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 January 31, 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 31 January 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.

201802-427764

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