Corporate Pension Liability Hedging Views October 31, 2014
Key Liability Hedging Messages for October 31, 2014 Interest rates are low today: - US Treasury yields remain low relative to history HEK is currently bearish on fixed income: - We believe that rates will rise faster than implied by what is priced into fixed income markets, although not as quickly as previously thought HEK favors long credit: - Long credit spreads are now almost on par with the HEK fair value, we favor long credit relative to other liability hedging fixed income types HEK currently recommends a deferred or phased approach to duration extension for new liability hedging assets: - Some sponsors may consider shortening duration (via physical bonds or derivatives) in response to recent interest rate declines. - Sponsors may consider delaying any planned duration extensions in this environment. - A Hedge Path is a systematic approach to extend duration over time based on the level of interest rates and funded status 1
Market Yields as of October 31, 2014 HEK is bearish on fixed income today Credit Gov t Benefit Payments Years 0-10 Intermediate Credit (2.3%) Intermediate Gov t (1.1%) Benefit Payments Years 11-20 Long Credit (4.5%) Long Gov t (3.0%) Benefit Payments Years 20+ STRIPS STRIPS < 10 years (1.3%) STRIPS 10-20 years (2.8%) STRIPS 20+ years (3.1%) Swaps Swaps 5 year (1.8%) Swaps 15 year (2.8%) Swaps 30 year (3.1%) Yields on Barclays Indices as of Oct. 31 Green (Favorably Priced), Amber (Consider), and Red (Expensive). 2
Spreads Yields Market Yields - Recent Trends 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Yield Movements Over the Past 3 Years Long Credit Long Gov Int Credit Int Gov HEK Fair Value (Long Credit) Spread Movements Over the Past 3 Years Long Credit OAS Int Credit OAS HEK Fair Value Spread (Long Credit) 6.20 4.51 2.95 2.27 1.15 1.72 1.68 0.88 We expect interest rates to rise: Our view is that the steep decline in yields that we have seen over the first several months of 2014 has been a market overreaction and is likely to be reversed within the short to medium term. Long Credit yields are currently 1.7% below HEK s fair value: Long Credit Yields will need to rise by around 1.7% to reach our estimate Long Term Fair Value HEK favors Long Credit Spreads: Long and Intermediate credit spreads have risen slightly over the past couple of months. In relative terms, we feel that Long credit spreads are more attractive than Intermediate credit spreads. 3
Medium Term Outlook on Interest Rates 5% 4% 3% 2% 1% Market Implied Forward Yield Curves Market: At a 15 year duration interest rates are priced to rise by 0.5% over 3 years and 0.6% over 5 years (forward rates). 0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Duration Yield curve at October 31, 2014 Implied yield curve at October 31, 2017 Implied yield curve at October 31, 2019 Aon Hewitt 5yr view Market Expectations 15yr duration Oct-31-14 2.9% Increase from today Oct-31-15 3.1% 0.2% Oct-31-17 3.4% 0.5% Oct-31-19 3.5% 0.6% Aon Hewitt 3yr view MTV Expectations 15yr Increase from duration today Now 2.90% In 1yr 3.50% 0.60% In 3yrs 3.75% 0.85% In 5yrs 4.25% 1.35% Difference: HEK MTV vs. Market Delta In 1yrs + 0.4% In 3yrs + 0.4% In 5yrs + 0.8% HEK: Our expectation is that 15 year duration interest rates will rise by 0.85% over 3 years and 1.35% over 5 years. Opinion: Bearish Consequently, we are bearish on long bonds. * Totals may not sum exactly due to rounding 4
1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Risks are asymmetric risk of yields rising more sharply cannot be ignored 6 5 4 US 10yr Term Premium Our views assume gradual rise in Fed Funds rate and only slight reversion in the term premium (the additional yield that investors in long dated bonds require as compensation for investing in long dated bonds). 3 2 1 0-1 Long term average 20yr average Aon Hewitt view We assume the term premium remains well below its long term average and average of past 20yrs due to low inflation and Fed management of rate expectations. Key risk to our forecast is that the term premium moves up more sharply than we have assumed. All else being equal, long duration bonds will underperform intermediate if the term premium reverts faster than we expect. We recommended portfolios should be positioned short of target duration to guard against this risk. 5
Hedging Medium Term Views Strong Preference Modest Preference Neutral Modest Preference Strong Preference Intermediate Long duration duration rates rates Government Credit Intermediate Long Credit Credit Spread Spread 6
Appendix I: Factors Affecting Interest Rates
Primary Near -Term Factors Restraining Treasury Yields Federal Reserve actions A key driver of low yields is the Federal Reserve's presence throughout the yield curve. The Federal Reserve has abandoned guidance linking the first increase in the Fed Funds rate to a 6.5% unemployment rate. The first rate rise will come much later The Fed's asset purchase program remains a factor restraining yields Inflation staying low Long-term inflation expectations are staying well bounded at just over 2% annually Realized core inflation has been low in the past two years, and remains low in the developed world Spillover from Eurozone Weak Eurozone economic conditions, particularly worries over deflation, led to a large fall in yields which as spilled over into U.S. treasury bonds 8
Primary Medium-to Long-Term Factors Pushing Yields Upward Our view is that the medium to longer-term drivers point to higher yields Growth and Inflation will normalize monetary policy The recent pronounced flattening of the US yield curve seems to be at odds with economic conditions generally strengthening. We believe that economic recovery will hold. We expect inflation to be moving back to target as capacity slack is now more or less fully utilized. Current projections that short-term interest rates will average zero in real terms over 10 years is unreasonable, as it implies an excessively easy monetary stance from the Fed. Federal Reserve support eases The Federal Reserve's bond purchases have kept yields lower this year than otherwise as it has absorbed a big part of (smaller) treasury bond issuance. As economic recovery is better established, there will be less urgency to manipulate bond yields lower. The Federal Reserve is anxious about excesses in risky asset markets and its communication is likely to turn less dovish. Term premium will revert back The term premium on US treasury bonds has fallen back again, but we expect it will gradually recover as interest rate uncertainty comes back into the picture. Inflation risk seems low at present, but as inflation rises, uncertainty around future inflation could also be a factor that brings the term premium back. 9
HEK s Current View on Interest Rates Summarized We see Treasury yields rising by more than the yield curve is discounting. Yield curves show 15 year duration yields are expected to rise 0.2% and 0.5% over the next 1 and 3 years. Our views are 0.6% and 0.85%, respectively. We expect higher-than-market implied real short-term interest rates and a reversion of the term premium to more normal levels. Our view sees the fall in US yields this year as the result of temporary factors which will reverse. However, the upward move in yields should be less steep than the 2 nd half of 2013. HEK s interest rate views appear slightly below consensus projections from market participants (a mix of investment banks, research institutes and asset managers). 10