Investing December 10, 2020

More of the Same Expected for Rates, Inflation in 2021

Interest rates were already stuck at stubbornly low levels even before the outbreak of the coronavirus pandemic, and the federal government has since signaled a commitment to accommodative monetary policy.

Reported by

During a recent webcast sponsored by Natixis Investment Managers, two fixed-income experts shared their hopes and concerns for what might be coming in 2021.

The speakers were Elaine Stokes, executive vice president and portfolio manager at Loomis, Sayles & Company; and Adam Abbas, portfolio manager and co-head of fixed income, Harris Associates. The pair noted that fixed income market watchers should now have little doubt that a “new normal” for interest rates is firmly in place. This is to say that rates were already stuck at stubbornly and historically low levels even before the outbreak of the coronavirus pandemic, and the federal government has since signaled a commitment to supporting the markets and the economy through accommodative monetary policy.

Never miss a story — sign up for PLANSPONSOR newsletters to keep up on the latest retirement plan benefits news.

“Central bank support is now basically the rule, wherever you look around the globe,” Stokes said. “Interest rates are low or even negative wherever you look. It’s much more than just a United States challenge.”

Stokes and Abbas said this dynamic will clearly present lasting performance challenges for investors who traditionally seek to rely on “safe assets” to drive the bulk of their portfolio returns. They suggested such conditions should give active managers a chance to shine, particularly when it comes to fixed income. At the same time, these conditions underscore the fact that government bonds and investment-grade corporate debt may now be more important as risk-ballasts in a diversified institutional portfolio, rather than return drivers, as they might have been in the past. 

When it comes to overall market volatility, Stokes and Abbas said they expect less in 2021.

“One thing that created a lot of volatility in 2020, beyond the pandemic, was political division and disagreement,” Stokes observed. “I think and hope that 2021 will bring back more conventional political tactics and strategies. This would help to bring back a longer-term view about the global economy’s potential, and that could help to give the markets more comfort. That said, depending on the outcome of the Senate runoff elections in Georgia, we will still have a divided government, and most likely at least some tensions will continue to play out.”

Stokes and Abbas said the rollout of the various coronavirus vaccines in 2021 should slowly start to reveal exactly what parts of the economy could be irrevocably changed moving forward. The pair said it remains to be seen, for example, what long-term impacts there could be on future levels of business and leisure travel. Another unknown is how commercial real estate will be impacted once the acute challenges of the pandemic have been overcome.

When it comes to the inflation outlook, Stokes and Abbas voiced very little concern. They said some areas of the U.S. and global economy could see modest inflation in 2021, but, on the other hand, other areas could face deflationary pressure. Cases in point, they noted that employee productivity has meaningfully increased this year, while serious slack has developed in the labor market. Both factors should help keep inflation in check, they said.

Consensus Views From Vanguard

The same day that Natixis presented Stokes’ and Abbas’ commentary, Vanguard published its 2021 market outlook report, “Vanguard Economic and Market Outlook 2021: Approaching the Dawn.”

At a high level, the report concludes the next phase of recovery depends on greater immunity to COVID-19 and a return to consumers engaging in normal economic activities.

“Should a vaccine become distributed, administered broadly and be effective, much of the economic losses from COVID-19 could be recovered in the next year,” Vanguard suggests. “That said, there is risk that if immunity does not rise, economies may only see marginal progress from current levels.”

According to the report, Vanguard economists expect interest rates globally to remain low, despite a constructive outlook for firming global economic growth and inflation as 2021 progresses.

“While yield curves may steepen, short-term rates are unlikely to rise in any major developed market, as monetary policy remains highly accommodative,” the report says. “Vanguard expects bond portfolios, of all types and maturities, to earn returns close to their current yield levels. As 2021 unfolds, the greatest risk factor would appear to be higher-than-expected inflation.”

The Vanguard report projects that inflation should cyclically bounce higher in the middle of 2021 from current lows, before plateauing near 2%, “but such a move could introduce market volatility.”

“In 2020, disciplined investors were yet again rewarded for remaining invested in the financial markets despite troubling headlines and a challenging environment,” the report explains. “For 2021, the wisdom will be to maintain that same level of discipline and long-term focus, while acknowledging returns may moderate from the past.”

The report concludes that economic growth and inflation will likely “stay even lower for longer” after the first phase of the economic recovery, and with the markets expecting loose monetary policy to persist.

“We find it hard to see any material uptick in fixed-income returns in the foreseeable future,” the report says. “Instead of viewing this asset class as a primary return-generating investment, investors are encouraged to view bonds from a risk-mitigating perspective. Our analysis in last year’s outlook suggested that bonds maintain their diversification benefits despite low-to-negative global yields; the events of 2020 only confirmed that.”

Investing December 10, 2020

DB Plan Sponsors Looking to New Vehicles for LDI Strategies

Diversification is a focus for fixed income investments, and experts shared thoughts about strategies during a roundtable event.

Reported by

With the continued low interest rate environment and wide volatility in the stock market, defined benefit (DB) plan sponsors are trying to figure out how to invest to keep their liability-driven investing (LDI) strategies successful.

During Insight Investment’s expert roundtable, “A 2021 Roadmap for Institutional Investors,” Kevin McLaughlin, head of liability risk management, North America, noted that the goal of an LDI strategy is to have assets track liabilities, and, with so much uncertainty in the markets, DB plan sponsors are focused on funded status volatility.

For more stories like this, sign up for the PLANSPONSOR NEWSDash daily newsletter.

There is also a growing focus on liquidity, he said. Especially for frozen DB plans, there are more outflows than inflows. “Over the next 10 years, DB plans could see outflows between 50% to 80% of assets,” McLaughlin said. “In the public DB plan space, some of those numbers are even more stark.”

Alex Veroude, chief investment officer (CIO), North America, said investors are wondering whether the 10-year Treasury note will break the 1% mark since it’s close to doing so now. However, he said Insight Investment’s view is that the world is in a state of financial repression, so it thinks real yields will be low, zero or negative in 2021. “If inflation is high, we’ll see a negative rate situation,” Veroude said.

Shivin Kwatra, head of LDI portfolio management, North America, said it is tempting in the current rate environment to take off hedges in a portfolio, but DB plan sponsors are resisting the temptation, and Insight Investment agrees with that decision. “Hedges should be part of a plan’s risk management program. We are suggesting plans think about increasing hedges,” he said.

Kwatra said, currently, most fixed income investments are in government bonds and STRIPS [Separate Trading of Registered Interest and Principal of Securities], and some of that could be achieved more efficiently with overlays. For fixed income investments that are in corporate vehicles, he said, the big theme has been to diversify away from corporate allocation both in public and private markets for better protection diversification and yield.

“Should you take off hedges and hope interest rates rise, or should you the stay course and increase your hedge ratio?” McLaughlin queried. “We think that despite rates being low, plan sponsors should hedge liabilities. The more they can hedge, the more they can lock down investment goals they seek to achieve.” He added that many plan sponsors—both corporate and public—are in decumulation mode, so the second reason to focus on hedging is the need to build a buffer to shocks on funded status.

McLaughlin said there is more sensitivity to a fall in interest rates than a rise in interest rates. “If rates decline further, the value of liabilities will increase 20% to 40%, but if rates rise, plan sponsors will only see a decrease in liabilities of 12% to 14%,” he explained. With this in mind, plan sponsors might be thinking about the risk of regret if they hedge too soon and rates rise—they’ll feel they lost out. But, McLaughlin said, it is better to be cautious in case rates fall.

“We see more focus on trying to make fixed income do more work. Plan sponsors are also more cash-flow aware to be able to pay for benefits,” he said. “Better hedges can free up liquidity.” McLaughlin added that before plan sponsors make investment decisions, they should ask if they are in a position to take on more risk.

Veroude said there will be a continued search for yield in the government bond space, and investors will find more yield in emerging markets and currencies tied to that, not in traditional bonds.

If DB plans can replicate Treasuries and STRIPS synthetically to free up capital, that should be a strategy, McLaughlin said. He also recommended that plan sponsors have three to five years of planned liquidity on hand.

Search for Growth

Going into 2021, DB plan sponsors are also asking where to turn for growth. “They are wondering if a large allocation to fixed income is still the best thing,” Veroude said. “We expect, and have already started to see, a rotation of investments in portfolios out of lower yielding assets and into other areas. Different asset managers have different answers for the best place to find growth.”

Veroude said there are fixed income vehicles that can provide diversification, negative correlation and yield/growth. “The next best thing might not be one single investment, but one to protect and one for growth,” he said.

In fixed income, growth will come from vehicles that don’t have a high propensity for default, Veroude said. Otherwise, investors should go straight to equities. “It would be nice to find investment vehicles that are not super crowded, but that’s easier said than done,” he said. “Investors can find some that are not over-crowded, but those vehicles are not widely advertised.”

There are two areas Insight Investment favors in the current market crisis: securitized investments and those with a liquidity premium—for example, private assets, particularly with lower default risk. “We think investors will increasingly skew their portfolios toward those,” Veroude said. “I think in five or so years, we will see DB plans’ fixed income allocations more in illiquid assets and less in government bonds. Intellectually, moving assets into private investments makes sense.”

In the search for yield, as plans allocate more assets to higher yielding securities, they will have to take on more risk, McLaughlin noted. Plan sponsors should ask if they can do that in a way to hedge liabilities. In the past, U.S. Treasuries were a hedge against equity risk, but diversification from Treasuries is now a theme, he said.

An equity with downside protection is fixed income-like, McLaughlin said. The challenge is the cost, but he said a “tremendous amount of work has been done to provide downside protection more efficiently than in the past.” Veroude said this is why he likes convertible bonds; they offer the upside of equity but if things go wrong, there is still the floor of an outright bond on hand. “They are coming back in vogue; 2020 has been a record year for the issuance of convertible bonds,” he said.

McLaughlin noted that there is hope for additional funding relief for DB plans. The Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act, which passed through the House in May, if passed in its current form, would extend the amortization period plan sponsors have for covering funding deficits. “It would mean lots of corporate plans can extend the time horizon for closing their funding deficit, so they could take on less risk and wouldn’t have to re-risk into equities,” he said.

«