Pension Funds: Time to Rethink Asset Allocation Strategies?
It is a common misconception that equities generally react similarly to bonds (and any other assets with fixed future cash flows) when faced with rising interest rates. Traditionally, asset owners—especially those managing defined benefit plans—looked to fixed income to hedge their liabilities (together with other asset classes). But is this really the best approach?
Duration in Equities vs Fixed Income
The concept of duration is well known in the bond asset class. It is the weighted-average time to receive the present values of all future cash flows (interest payments and capital reimbursements). The price sensitivity of a bond to changes in interest rates is equal to the negative of its duration—at least for small changes in interest rates.
While duration is well specified for bonds where cash flows are known with some certainty, the concept of interest rate sensitivity can be applied to other asset classes where cash flows are uncertain. In fact, we can estimate the interest sensitivity of any asset by time series regression.
We could calculate the duration of an equity asset based on its cash flow forecast and its equity discount rate. But do we really care about equity duration? With bonds, cash flows are fixed and any change in the interest rate used to discount those cash flows has an impact that is mathematically pre-defined. With equities, a change in interest rates will have an impact not only on the equity discount rate, but also on future cash flows.
Often, the market perceives an increase in interest rates as a signal that the economy is doing well. Following an increase in interest rates, financial analysts will assign higher probabilities to the more bullish scenarios, and lower probabilities to the more bearish scenarios, when it comes to projecting future cash flows. The result is a higher cash flow forecast discounted at a higher rate. Higher Cash Flow forecast increase value. But higher discount rates decrease value. Who wins? What is the net effect?
Equity Interest Rate Sensitivity or Duration?
Ultimately, we’re not actually interested in the duration of an asset per se. We are much more interested in an asset’s sensitivity to changes in interest rates. While in the bond market, duration and interest rate sensitivity are used interchangeably, this is not the case in the equity market. Fortunately, we can estimate equity interest rate sensitivity by time series regressions. Axioma provides such estimates together with other macroeconomic factor sensitivities.
US Equity Market – Long Term Interest Rate Sensitivity
Using a well-known broad benchmark, we aggregated the long-term interest rate sensitivities of individual stocks at the index level.
One striking observation we found was that over the last 10+ years, the US equity market interest rate sensitivity has generally been positive, while bond interest rate sensitivity was always negative (equal to minus duration). But why? As explained above, changes in rates have an impact on both the discount rate and future cashflows, so the net effect is positive interest rate sensitivity.
It does not mean that the equity market always reacts positively to increases in interest rates. If interest rates increase when market participants fear for the future outlook of the economy, the market may react negatively. But on average, at least for the past 10 years or so, on a rolling basis, the market has tended to react positively to increases in interest rates.
A different calibration of the time series regression used to estimate the above interest rate sensitivities could be more reactive (and noisier) and could perhaps lead to very short periods of slightly negative sensitivities. However, we’d still reach the same conclusion: contrary to the bond market, the US equity market on average reacted positively to rising interest over the last 10 years.
Strategic Asset Allocation Implication
While bonds react negatively to increases in interest rates, we observed an average positive correlation between equities and interest rates. Studies over longer terms have previously shown some negative relationship between interest rates and equities except over the last 20 years. If that positive relationship remains, it has interesting implications for defined benefit plans and other long-term pension plans with some kind of built-in inflation protection.
When inflation expectation increases, future/projected pension payments also increase, as does the actuarial discount rate. The net effect is generally an increase in the liability value of the pension plan.
Therefore, an increase in interest rates and inflation may generally lead to:
- increased pension liabilities
- lower bond prices
- higher equity values (at least over the last 10-20 years)
Equities may therefore provide a much better hedge than bonds against increasing interest rates. Strategic Asset Allocation studies taking this into account may lead not only to a greater percentage of assets invested in equities (because they better hedge the liabilities), but also to alternative equity strategies that target an interest rate sensitivity closer to the liabilities’ interest sensitivity. Controlling a portfolio’s interest rate sensitivity can also be used to enhance any strategy, either by neutralizing some unintended active interest rate bets, or by better exploiting a portfolio manager’s view of future interest rates.
Better Asset-Liability Matching Products?
Users of Axioma’s optimizer and risk models can control a portfolio’s interest sensitivity and target any level, in absolute or relative terms (relative to a benchmark). This allows asset owners to mute or exploit the adverse potential impact of interest rate changes. We can also envision the creation of new equity products that target an interest rate sensitivity equal to typical pension plan’s interest rate sensitivity.
Finally, while the analysis above focuses on the sensitivity of assets to changes in interest rates, clients can also focus on asset sensitivity to changes in inflation expectations. Axioma’s macroeconomic factor library provides these inflation sensitivity estimates, too.
For more information, contact us.