What Falling US Interest Rates, Negative Global Yields Mean for Asset Allocators

Art by Wenting Li

A year ago, U.S. interest rates were rising, allowing asset allocators to find higher yields in safer fixed-income vehicles. Fast forward to 2019 and between the Federal Reserve cutting interest rates and nearly $17 trillion in global debt with negative yields, the script completely flipped.

That’s left asset allocators in a tough spot: How do they find yield in this environment and what do they do about higher liabilities caused by the yield drop? Stronger equities and positive total return in fixed income helped somewhat, but those gains aren’t enough to offset greater unfunded liabilities.

Jeffrey Sherman, deputy chief investment officer at DoubleLine, says the current interest rate environment has pushed pension funds to embrace again the riskier investments of private equity, private debt, venture capital and other alternatives. “What’s happening is it’s forcing pensions plans to rethink what they can actually own,” he says.

In a recent example, the Virginia Retirement System, an $82 billion system, just revised its asset allocation to take on more risk.

Pension plans are acknowledging the idea that U.S. interest rates will be low for a very long time, says Jay Love, partner at investment consultant firm Mercer. “Most of our clients tend to think much more in terms of total return and the overall risk exposures they want to have,” he says.

Burned by rate drop

Love says their clients who took advantage of pre-fourth quarter 2018 equity gains and the rise in interest rates to somewhat de-risk their plans and increase their overall interest rate hedge ratio are in a “fairly good position.”  He says they haven’t been as exposed to falling rates.

Those who didn’t act, hoping for further rate rises were exposed to abrupt drop in rates this year, he says. Love says Mercer doesn’t forecast any further meaningful drop in U.S. rates, nor do they expect U.S. rates to go to negative. “You can’t rule that out anywhere at this point, but it’s a fairly distant worry for the U.S.,” he says.

Andrew Catalan, head of long duration at asset manager Insight Investment, says his firm’s research department pondered the idea of negative-yielding U.S. Treasurys, although that’s not their forecast. Insight Investment suggests if U.S. rates turned negative, the overall discount rate would stay positive because of the corporate bond spread used to discount the liabilities. The discount rate, however, would fall significantly. Pension funds not fully hedged would see their funded status deteriorate greatly because equity returns likely couldn’t offset the drop.

“Because (the U.S. economy) is still growing above trend, you can justify the 10-year being above 2%. Our 12-month forecast is for the 30-year being over 2.6%. But the reality is that negative yielding debt is suppressing the yield levels here, so it’s not completely in our control,” Catalan says.

Another view

Anne Mathias, global rates and foreign exchange strategist in Vanguard Fixed Income Group, says negative yielding debt is a challenge for asset allocators. But she suggests other ways to look at this phenomenon.

Holders of negatively yielding debt in most instances still get a positive coupon payment on a regular basis. Additionally, investors who buy negative yielding instruments may think deflation is ahead. In that case, money in the future may be worth more than money today.

“By purchasing this instrument, you’re basically putting your money in safe-keeping, in a weird way,” Mathias says.

Vanguard’s active funds that invest in European sovereign debt are looking to take advantage of differentials, such as the spread between Spanish or Portuguese sovereign bonds and German sovereign bonds and how it might change. “For us, in that kind of strategy, the level of yield is less important than the differential change in yield between two instruments,” she says.

Mathias says an investment’s currency-adjusted returns now are an important part of total returns. Depending on how much it costs to hedge yen investments in euros versus dollars, Japanese investors may find European sovereign bond investments more attractive. That’s because it’s less expensive as a yen investor to hedge euro-based investments than hedging U.S.-dollar investments.

Alternatives to fixed income

Fixed-income’s capital appreciation led to strong total returns, but DoubleLine’s Sherman says it covers a bigger problem. “It means you’re eking away from future returns because rates have gotten lower,” he says.

John Delaney is senior director and portfolio manager, investments, at Willis Towers Watson. Delaney runs the firm’s discretionary portfolios and says he’s preparing clients for either a U.S. recession or that the economy will “muddle through” because the Fed eases enough to avoid a recession. “You’ll need income for your portfolio to generate returns in either of those types of scenarios to protect your downside,” he says.

With that view, he says real assets look attractive still, whether in the form of listed investments like real estate investment trusts or direct purchase, since these can increase income without high volatility. He likes regional infrastructure in listed investments since those pay favorable dividends. He’s eschewing pricey corporate stocks and debt, saying the high-yield market is “basically pricing in perfection.” Some of his clients are moving from investment-grade corporates to Treasurys for downside protection.

Sherman also advocates for short-term U.S. Treasurys to avoid expensive, riskier investments. “It’s like when the stock market is overvalued, you don’t have to play it. As professional investors you have to invest, but that doesn’t mean you have to take more risks,” he says.

He said, however, that pension plans still need to fund the liabilities, which may mean more contributions from the employees or employer or cuts to benefits. Some pension fund are cutting benefits, such as Detroit Carpenters’ Pension Trust Fund.

Dropping U.S. rates spurred a rash of new government and corporate issuance and refinancing older, higher-coupon debt into cheaper debt with longer duration. So much new and refinance paper appeared that government and corporate fixed income indices now sport longer duration. Catalan says corporate index duration is now closer to 14.5 years versus 13.5 years.

Mathias agrees, noting this extended duration creates convexity risk for investors following index valuation, so portfolio managers now must rethink how to manage the convexity profile. At Vanguard they’re considering options such as pairing that convexity risk with mortgage-backed securities with a negative convexity.

“On the flip side, if you’re a long-duration investor where your liabilities are longer-dated, you actually might like it because you have less of a liability duration mismatch,” she says.

Borrowing to fund liabilities

The low rates offer pension funds an opportunity to shore up underfunded plans. Connecticut State Employee’s Retirement System seeks to reamortize part of the state’s liability. Avery Dennison borrowed to contribute $200 million in cash as it decided to terminate its U.S. pension.

FedEx issued at $1 billion bond with a 10-year maturity with a yield of 3.1%, which would in part help fill in its pension funding gap. The shipper’s bond offering is cheaper than the insurance fee the Pension Benefit Guaranty Corporation insurance fee for unfunded pension liabilities of 4.3%.

Love says this borrowing is attractive for several reasons. “The interest cost is tax-deductible. They get lower PBGC premiums; they get more money in the plan to generate future returns and to lower their overall expense. So, there are a lot of positive aspects to borrowing at these low rates and using it to fund your plan,” Love says.

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