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Pension Curve Insider

Pension Curve Insider: LDI Solutions November Monthly Recap

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

Monthly Recap

Marked-to-market discount rates jumped again in October as Treasury yields continued to rise during the month. Both the AA-rated spot curve and the top-yielding curve gapped up from prior month-end. The short and long ends of the curve rose the most, around 15 basis points, while the belly of the curve rose around 5 basis points. Investment grade spreads finished the month mostly unchanged while discount rates based on the IRS curve, with its averaging methodology, also rose during the month.

Discount rates currently sit 66 basis points higher than a year ago, using the broad AA discount rate curve. Top yielding AA-rated bonds are 54 basis points higher than October 2017 and provide 18 basis points of additional yield relative to the broader market.  

October saw a slowdown in turnover within the AA-rated index, with just over 1% of the index changing eligibility. New issues made up most of the month’s movement, totaling about $7B in market value. The Canadian Provinces of Alberta and Ontario each had new U.S. dollar offerings during the month, maturing at the 5-year tenor and accounting for nearly $5B in market value. An upgraded rating to the city of Nashville also impacted the curve. Their 2043-maturity bond helped shift the discount at the 25-year mark. Exiting bonds during October did not materially impact the curve.

Liability Impact

Yield Curve

Liability Value 10/31/18

Discount Rate 10/31/18

Liability Value 9/30/18

Discount Rate 9/30/18

Liability Value 12/31/17

Discount Rate 12/31/17

Accounting
Yield Curve

$9, 394

4.47%

$9,679

4.25%

$10,386

3.73%

Top Yielding
Accounting Curve

$9,181

4.65%

$9,425

4.45%

$9,994

4.01%

IRS Yield Curve

$9,305

4.52%

$9,520

4.35%

$10,310

3.76%

Sources: Bloomberg Index Services Ltd. Copyright © 2018, Bloomberg Index Services Ltd. Used with permission. IRS and Analysis by T. Rowe Price.
Sample plan cash flows have a liability of $10,000 at 4.0% discount rate. 

Accounting Curve

Sources: Bloomberg Index Services Ltd. Copyright © 2018, Bloomberg Index Services Ltd. Used with permission. Analysis by T. Rowe Price. 

Issuer

Event

Curve Impact

Provinces of

Ontario and

Alberta

New Issue

(1 bond)

The Province of Ontario issued a $2.5B bond while the Province of Alberta issued a $2.3B bond during October. Both new issues will mature at the 5-year mark and helped push the AA-rated discount curve down 3 basis points. The market value of the two issues accounts for nearly 70% of the month’s bonds changing eligibility.


Nashville

Upgrade

(1 bond)

October also saw a smaller bond impact the discount curve. An upgrade of the Metropolitan Government of Nashville saw one of its $400M bonds enter the AA-rated universe. Due to limited issuance at longer durations, the 25-year bond moved the discount curve 3 basis points at the long end, despite only accounting for 5% of the month’s changing market value.

Sources: Bloomberg Index Services Ltd. Copyright © 2018, Bloomberg Index Services Ltd. Used with permission. Analysis by T. Rowe Price. 

 

New Issues

Other Bonds Entering

Downgrades

Other Bonds Exiting

October 2018

Count

4

1

0

2

Market Value ($M)

$6,273

$425

$0

$1,057

Market Value (%)

0.96%

0.06%

0.00%

0.16%

 
2018 YTD

Count

76

65

26

22

Market Value ($M)

$72,293

$63,780

$21,552

$24,066

Market Value (%)

11.31%

9.91%

3.52%

3.81%

Sources: Bloomberg Index Services Ltd. Copyright © 2018, Bloomberg Index Services Ltd. Used with permission. Analysis by T. Rowe Price.
 

TOP YIELDING ACCOUNTING CURVE

Sources: Bloomberg Index Services Ltd. Copyright © 2018, Bloomberg Index Services Ltd. Used with permission. Analysis by T. Rowe Price.

IRS Curve

Dates

AAA Corporate OAS

AA Corporate OAS

A Corporate
OAS

September Monthly Average

45

49

84

October 1, 2018

41

46

81

October 15, 2018

43

49

84

October 31, 2018

48

56

92

October Monthly Average

45

50

85

Sources: Bloomberg Index Services Ltd. Copyright © 2018, Bloomberg Index Services Ltd. Used with permission. Analysis by T. Rowe Price.  

One-Year Rolling Returns and Tracking Error

 

October 2018 Return

YTD Total
Return

Annual Tracking Error Relative to Liability

Average Monthly
Return Difference from Liability

Hypothetical Sample Plan Liability

-2.61%

-6.67%

NA

NA

BBgBarc Aggregate

-0.79%

-2.38%

6.51%

1.42%

BBgBarc Long Credit

-3.61%

-8.63%

4.54%

0.93%

BBgBarc Long Gov/Credit

-3.35%

-8.58%

3.15%

0.65%

Hypothetical T. Rowe Price Custom Benchmark

-2.68%

-6.89%

2.04%

0.32%

Sources: Bloomberg Index Services Ltd. Copyright © 2018, Bloomberg Index Services Ltd. Used with permission. Analysis by T. Rowe Price. Performance shown in graph and tables above shown from February 1, 2005 through October 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.  

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 October 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.

201811-653658

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