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Pension Curve Insider: LDI Solutions April Monthly Recap

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

Monthly Recap

Marked-to-market discount rates declined significantly in March as the Treasury curve inverted. The short end of the curve moved down modestly while the middle and long end collapsed between 20 and 30 basis points. Discount rates generated using the AA-rated spot and top-yielding curves followed suit and fell by 29 and 25 basis points, respectively. Spreads had a muted reaction, with A and AA rated bonds contracting a few basis points while AAA spreads moved up 3 basis points. Discount rates based on the IRS curve, with its averaging methodology, also fell during the month.

After the move, discount rates now sit 13 basis points lower than a year ago, using the broad AA discount rate curve. Top yielding AA-rated bonds are 4 basis points lower than March 2018 and provide 29 basis points of additional yield relative to the broader market.

Turnover slowed down in March, as about 1.5% of the AA-rated index changed eligibility during the month. Exiting bonds made up most of the month’s changing market value and consisted of a key downgrade to the LA Unified School District. Much of the remaining turnover took place at the short end of the curve, but had a muted impact on discount rates.

Liability Impact

Yield Curve

Liability Value 3/31/19

Discount Rate 3/31/19

Liability Value 2/28/19

Discount Rate 2/28/19

Liability Value 12/31/18

Discount Rate 12/31/18

Accounting
Yield Curve

$10,207

3.86%

$9,805

4.15%

$9,695

4.24%

Top Yielding
Accounting Curve

$9,806

4.15% $9,485 4.40% $9,446 4.43%

IRS Yield Curve

$9,790

4.14% $9,703 4.20% $9,400 4.44%

Sources: Bloomberg Barclays. Bloomberg Index Services Ltd. Copyright 2019, Bloomberg Index Services Ltd. Used with permission. IRS, and T. Rowe Price. Sample plan cash flows have a liability of $10,000 at 4.0% discount rate.

Accounting Curve

Sources: Bloomberg Barclays. Bloomberg Index Services Ltd. Copyright 2019, Bloomberg Index Services Ltd. Used with permission. T. Rowe Price.

Issuer

Event

Curve Impact


LA Unified School District

Downgrade

(3 bonds)

March saw the LA Unified School District get downgraded from AA- to A+ by Standard and Poor’s. As a result, the AA-rated index lost 3 LAUSD bonds totaling more than $3B in market value. The curve impact was felt at the 10 and 15-year points, declining 10 basis points in total due to the exiting bonds.

California/ University of California

New Issue

(3 bonds)

The state of California issued 2 new bonds in March while the University of California brought one new issue to market. The bonds mature at the 7 and 10-year points and account for about $1B in market value. The largest curve impact occurred at the 10-year mark, rising 3 basis points due to the new issues.

Sources: Bloomberg Barclays. Bloomberg Index Services Ltd. Copyright 2019, Bloomberg Index Services Ltd. Used with permission. T. Rowe Price.

 

New Issues

Other Bonds Entering

Downgrades

Other Bonds Exiting

March 2019

Count

5

0

3

2

Market Value ($M)

$3,241

$0

$3,373

$2,199

Market Value (%)

0.50%

0.00%

0.52%

0.34%

 
2019 YTD

Count

25

5

5

18

Market Value ($M)

$21,376

$5,553

$6,957

$16,126

Market Value (%)

3.31%

0.86%

1.07%

2.50%

Sources: Bloomberg Barclays. Bloomberg Index Services Ltd. Copyright 2019, Bloomberg Index Services Ltd. Used with permission. T. Rowe Price.

Top Yielding Account Curve

Sources: Bloomberg Barclays. Bloomberg Index Services Ltd. Copyright 2019, Bloomberg Index Services Ltd. Used with permission. T. Rowe Price.

IRS Curve

Sources: IRS and T. Rowe Price

Dates

AAA Corporate OAS

AA Corporate OAS

A Corporate
OAS

February Monthly Average

54

53

89

March 1, 2019

54

50

85

March 15, 2019

56

48

86

March 29, 2019

58

51

87

March Monthly Average

56

49

86

Sources: Bloomberg Barclays. Bloomberg Index Services Ltd. Copyright 2019, Bloomberg Index Services Ltd. Used with permission. T. Rowe Price.

One-Year Rolling Returns and Tracking Error

 

March 2019 Return

YTD Total
Return

Annual Tracking Error Relative to Liability

Average Monthly
Return Difference from Liability

Hypothetical Sample Plan Liability

4.40%

6.24%

NA

NA

BBgBarc Aggregate

1.92%

2.94%

6.46%

1.41%

BBgBarc Long Credit

4.33%

7.86%

4.51%

0.92%

BBgBarc Long Gov/Credit

4.70%

6.46%

3.11%

0.64%

Hypothetical T. Rowe Price Custom Benchmark

3.93%

6.23%

2.03%

0.32%

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 March 31, 2019.
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 2019, 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 March 2019 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. © 2019 T. Rowe Price. All rights reserved.

201811-653658

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