Uh-Oh, High-Yield Bond Downgrades Expand | Chief Investment Officer

Looking for impending trouble in the economy? There’s a new worry: Junk bonds, which suffer the most in a recession, are looking at a surge in credit-rating downgrades vs. upgrades.

According to Moody’s Analytics, the ratio of high-yield downgrades to upgrades has doubled—to 2.38:1 for January-September 2019, from 1.09:1 for calendar 2018. A revenue fall is to blame.

“A pronounced slowing by business sales, both with and excluding energy products, helps to the explain the marked excess of high-yield downgrades over upgrades after omitting primarily event-driven rating changes,” wrote John Lonski, the organization’s chief economist.

Sales growth, viewed as a three-month moving average and stripping out volatile (and lately in the tank) energy companies, slowed to 1.7% as of August, compared to a 5.6% pace the year before. During the last earnings deceleration in 2015 and 2016, the ratio soared to 3.44:1, way up from 0.99:1 in mid-2009, right after the Great Recession officially ended.

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Overall earnings are on the downswing, which doesn’t bode well for bonds at the non-investment grade end of the scale. The FactSet consensus of analysts indicates a third straight year-to-year slide of 4.1% for S&P 500 earnings per share in the just-completed third quarter.

A continued profit slide, in turn, likely could lead to a scramble into Treasury bonds, and this would widen the spread to junk. That would further harm the high-yield market.

“If core profits do not significantly surpass these downbeat forecasts, the 10-year Treasury yield may average something no greater than 1.7% through the end of 2020,” economist Lonski said. “And if a recession materializes, the bottom will fall out for Treasury yields and the benchmark 10-year yield probably slips under 1%.”

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Tags: downgrades, Earnings, Junk Bonds, Moody’s Analytics, sales, upgrades

Defined benefit pension plan sponsors should consider the pros and cons of limiting – rather than eliminating – pension risks over time, according to MassMutual.

A recent white paper from the life insurance firm says companies looking to mitigate the financial risks that come with defined benefit plan sponsorship can use a variety of strategies to manage pension risks, such as freezing plans to new entrants, hibernating plans, re-allocating investment assets or shifting pension obligations via a pension risk transfer.

“There are several different risk strategies for employers to contemplate when managing pension risks over both the short and long term,” Neil Drzewiecki, MassMutual’s head of pension risk transfer, said in a release that was issued with the white paper. “More employers are concluding that transferring those risks to a life insurer is in the best interests of the company and its employees.”

Drzewiecki said employers that sponsor defined benefit plans are increasingly recognizing the value of pension risk transfer annuities. The white paper points out that pension buy-out transactions are the only way to eliminate pension obligations under current law, and that they have grown nearly seven-fold to $26.4 billion in 2018 from $3.84 billion in 2013, according to the LIMRA Secure Retirement Institute.

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However, the surge in pension risk transfer has led to rising premiums paid by employers to the Pension Benefit Guarantee Corp. (PBGC), which is passing on higher costs to guarantee pension payments, according to the white paper. PBGC premiums for single-employer plans have more than doubled in the past 10 years, rising to $80 per participant in 2019, and they’re expected to continue to rise over the next decade.

“The latest federal budget proposal calls for PBGC premiums for collectively bargained retirement plans to rise by $18 billion over the next 10 years,” said the white paper. “Whether those figures become reality or not, it’s unlikely that premiums will decline anytime soon.”

Among the several short-term and long-term strategies for managing pension risks cited by the white paper are hibernating risks, hedging risks, and purchasing annuities.

Hibernating risks closes a plan to any new entrants and stops accruals for participants in order to limit the financial risks of the plan while allowing the sponsor to continue to manage the plan. Although this protects against the risk of benefit increases, plans are still exposed to many other risks, especially interest-rate risk.

“Hibernation may not be a panacea for every pension plan or pension risk management objective,” said the paper. “Once in hibernation, the pension must continue to be managed to some degree and therefore continues to incur costs, including investment management expenses.”

Hedging risks can help lower risk and create less volatility. MassMutual says the fixed income assets that a plan invests in can be selected in a way to match the liability’s sensitivity to interest rate movements to offset changes in the plan’s liabilities. When interest rates decrease, the asset portfolio will increase in value in an amount close to the increase in liabilities.

Annuities are becoming increasingly embraced by Americans as a vehicle to accomplish their financial goals, according to the white paper. According to MassMutual, sales of group annuities have nearly doubled in two years, climbing to $26 billion in 2018 from $13.7 billion in 2016.

“The growing popularity of PRTs is good news for both plan sponsors and participants,” Drzewiecki said. “When a plan participant receives a notice in the mail that his or her pension benefit will be paid by a financially secure, experienced life insurer with great service, it’s good news.”