Download U.S. Corporate Pension Liability Hedging Views at 6/30/2015.

Corporate Pension Liability Hedging Views
June 30, 2015
Aon Hewitt
Retirement and Investment
Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. an Aon Company.
Nothing in this document should be construed as legal or investment advice. Please consult with your independent professional for any such advice. To protect
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Key Liability Hedging Messages for June 30, 2015

With considerable volatility, long-dated yields continued to head higher during June

The long bond (30yr) yield is now approaching 1% higher than the January low

We now take a more neutral stance on fixed income
– Market pricing has been moving towards our views and we no longer think the market is seriously mispriced
– We expect yields to head higher over the medium term but this is now almost fully reflected in market pricing
– Yields will continue to be volatile and the path to higher yields will not be smooth. There is an elevated risk that
yields rise or fall sharply over relatively short periods of time. Yields could overshoot our medium term views over
short periods.

We continue to prefer long credit over other hedging instruments
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Market Yields as of June 30, 2015
AHIC is now more neutral on fixed income. Market pricing is closely aligned with AHIC’s medium term
views regarding future yield movements.
Benefit Payments
Years 0-10
Benefit Payments
Years 11-20
Benefit Payments
Years 20+
Credit
Intermediate Credit
(2.6%)
Long Credit
(4.9%)
Gov’t
Intermediate Gov’t
(1.2%)
Long Gov’t
(3.0%)
STRIPS
STRIPS < 10 years
(1.4%)
STRIPS 10-20 years
(2.8%)
STRIPS 20+ years
(3.2%)
Swaps
Swaps – 5 year
(1.8%)
Swaps – 15 year
(2.7%)
Swaps – 30 year
(2.9%)
*Yields on Barclays Indices as of June 30, – Green (Favorably Priced), Amber (Consider), and Red (Expensive).
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Market Yields—Recent Trends
Yield Movements Over the Past 3 Years
Long Credit
Int Credit
Long Gov
Int Gov
8.0
4.24
5.70
4.90
3.02
2.56
4.0
2.0
Yields
4.0
6.0
Yields
Yield Movements Over the Past 3 Months
Long Credit
Long Gov
Int Credit
Int Gov
4.90
4.58
4.41
2.67
2.77
2.21
2.24
2.31
1.05
1.10
1.13
2.47
2.0
1.24
0.0
0.0
Spread Movements Over the Past 3 Years
Long Credit OAS
Int Credit OAS
2.5
Spreads

2.0
2.02
1.5
1.7
1.0
1.11


0.5
0.0
We expect interest rates to rise: Our view is that the steep
decline in yields that we have seen over the past year has
been a market overreaction and is likely to be reversed within
the short to medium term
Long Credit yields are currently 0.8% below AHIC’s fair
value: Long Credit Yields will need to rise by around 0.8% to
reach our estimate Long Term Fair Value
AHIC favors Long Credit Spreads: Long and Intermediate
credit spreads have fallen back over the past month. In relative
terms, we feel that Long credit spreads are more attractive
than Intermediate credit spreads
Source: Barclays Capital and AHIC
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3.02
4
2.56
1.24
Medium Term Outlook on Interest Rates
Market:

At a 15 year duration
interest rates are priced
to rise by 0.6% over 3
years and 0.8% over 5
years (forward rates).
AHIC:

Our expectation is that 15
year duration interest
rates will rise by 0.5%
over 3 years and 0.9%
over 5 years.
Opinion: We have now
moved to take a neutral
stance on yields
Source: Datastream, Aon Hewitt
MTV Expectations
15yr
Increase
Duration
From Today
Market Expectations
15yr
Increase
Duration
From Today
Jun-30-15
2.8%
Difference:
AHIC MTV vs. Market
Delta
Jun-30-16
3.1%
0.2%
In 1yr
3.10%
0.3%
In 1yrs
0.0%
Jun-30-18
3.4%
0.6%
In 3yrs
3.33%
0.5%
In 3yrs
- 0.1%
Jun-30-20
3.6%
0.8%
In 5yrs
3.75%
0.9%
In 5yrs
+ 0.1%
* Totals may not sum exactly due to rounding
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Risks Are Asymmetric
Risk of Yields Rising More Sharply Cannot Be Ignored

Term premium remains low
historically but has moved higher
over the past three months.

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).

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. If
this occurs then long duration
bonds will underperform
intermediate.
AHIC 5 Year
View
Source: New York Fed
The term premium is the additional yield that investors in long dated bonds require as compensation for investing in
long dated bonds as opposed to investing in a series of short dated bonds. i.e. 10yr yield = expected path for Fed
Funds rate over the next 10yrs + 10yr term premium.
The term premium is affected by a number of factors including how uncertain the interest rate outlook is and how
worried about inflation investors are. Increases in either of these factors would lead to a rise in the term premium.
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Hedging MTVs
Strong
Preference
Modest
Preference
Neutral
Modest
Preference
Strong
Preference
Intermediate
duration rates
Long duration
rates
Government
Credit
Intermediate
Credit Spread
Long Credit
Spread
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Appendix I:
 Factors Affecting Interest Rates
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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 Fed is influencing the yield curve by managing future rate
expectations
 Although not injecting new money into markets, the Fed continues to
reinvest the proceeds of maturing assets in the market, so its asset
purchase program remains a factor restraining yields.
Inflation Staying
Low
 Inflation expectations have been declining and are just over 2.0% a
year over the long run.
 Realized core inflation has been low over the past two years, and
remains low in the developed world.
 The large declines in the oil price will keep headline inflation low in the
near term and is also likely to have some spillover effects in core
inflation. This will ease the pressure on central banks to increase
interest rates in the near term.
Spillover From
Eurozone
 Continued Eurozone crisis risk is likely to see continued demand for
safe haven assets such as Treasuries
 US Treasury yields are very cheap compared with Eurozone bonds,
making them attractive in a global context to overseas investors
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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
 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.
 Against this backdrop, the Fed will be raising rates over time, likely
starting later this year
Federal Reserve
support eases
 The Federal Reserve’s bond purchases kept yields lower over 2014
than otherwise would be the case but these have now ended.
 As economic recovery is better established, there will be less urgency
from the Federal Reserve to manipulate bond yields lower.
 The Federal Reserve is anxious about excesses in risky asset markets
and its communication is already turning less dovish.
Term premium will
revert back
 The term premium on U.S. Treasury bonds had fallen to excessively
low levels but as we expected, this has proven unsustainable. The term
premium has picked up as interest rate uncertainty has come back into
the picture. We believe this has further to run over time
 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 further.
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AHIC’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 0.6% over the
next 1 and 3 years. Our views are 0.3% and 0.5%, 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 over the past year as the result of temporary factors
which will reverse.
 AHIC’s interest rate views are below consensus projections from market participants (a
mix of investment banks, research institutes and asset managers).
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Legal Disclosures and Disclaimers
© 2015 Aon
Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. (“AHIC”).
The information contained herein is given as of the date hereof and does not purport to give information
as of any other date. The delivery at any time shall not, under any circumstances, create any implication
that there has been a change in the information set forth herein since the date hereof or any obligation to
update or provide amendments hereto.
This document is not intended to provide, and shall not be relied upon for, accounting, legal or tax advice
or investment recommendations. Any accounting, legal, or taxation position described in this
presentation is a general statement and shall only be used as a guide. It does not constitute accounting,
legal, and tax advice and is based on AHIC’s understanding of current laws and interpretation.
This document is intended for general information purposes only and should not be construed as advice
or opinions on any specific facts or circumstances. The comments in this summary are based upon
AHIC’s preliminary analysis of publicly available information. The content of this document is made
available on an “as is” basis, without warranty of any kind. AHIC disclaims any legal liability to any
person or organization for loss or damage caused by or resulting from any reliance placed on that
content. AHIC. reserves all rights to the content of this document. No part of this document may be
reproduced, stored, or transmitted by any means without the express written consent of AHIC.
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