Schwab Bond Insights: Pensions and Munis, Oil Prices and High-Yield Bonds, Retirement Income
- We think the Treasury curve will continue to flatten, as short- and intermediate-term yields move higher as we approach the first rate hike. However, we believe long-term Treasury yields are likely to remain relative low in the near term.
- Rating agencies are paying more attention to municipalities' pension fund burdens.
- Energy companies are now the second-largest issuers of high-yield bonds. As a result, oil prices can have a significant effect on the high-yield bond market.
- We list three myths about retirement income strategies and explain why they're not true.
The FOMC announced the end of its third quantitative easing (QE) program this week, officially ending its bond buying that began over two years ago. This was generally expected by the markets.
While the Fed maintained its “considerable time” language with respect to the timing of first rate hike, the statement contained new text that stressed that the timing will be data-dependent. We still think the Fed is likely to first raise its target in mid-2015 but the recent volatility suggests that there are differing opinions among market participants about the timing of the first rate hike.
After plunging in mid-October, U.S. Treasury yields have rebounded as investors have gradually reversed their “risk-off” stance, which contributed to increased volatility and sharp declines in the riskier segments of the markets.
Long-term Treasury yields still remain near their 2014 lows, however. At 2.33%, the 10-year Treasury bond is still well below its 2013 close of 3.03%.
Short- and intermediate-term Treasury yields have seen more pronounced moves, helped by a less dovish statement at the recent FOMC meeting. The FOMC’s October statement pointed to further improvement in the labor market, and downplayed the recent lower trend in inflation.
We think the Treasury curve will continue to flatten, as short- and intermediate-term yields move higher as we approach the first rate hike. However, we think long-term Treasury yields are likely to remain relative low in the near term, with low inflation, continued geopolitical risks, and demand from foreign investors keeping yields in check.
What Muni Investors Should Know About Pension Funds
Rating agencies have begun to pay more attention to pension benefits, whose rising costs represent a burden on the $3.7 trillion municipal bond market. In fact, rating agencies have recently cited growing unfunded liabilities in their downgrades of some large issuers.
Detroit and two cities in California also mentioned the cost of employee pension funding as a contributor to their bankruptcy filings.
However, the media spotlight on the cost to fund public pensions may be good news for investors, as it has led politicians to acknowledge the issue and push for pension reform. Here, we'll discuss what this might mean for municipal pension funds, and what steps municipal investors can take.
How do pensions work?
State and local pensions are generally funded by a public employer—that is, the state or local authority. Public pension plans hold and invest contributions from an employer—and, to an increasing extent, public employees—to guarantee the employee a stream of lifetime payments in retirement.
The state or local government must contribute into its retirement system—in other words, a pension fund—to pay for future benefits. If the value of the plan’s assets fall, or the future retirement benefits promised become more expensive, the employer generally must contribute more. Those costs, of course, must compete with other costs, such as other public services or debt payments.
Funded pension levels vary greatly from state to state
In 2012, only four states saw their funded pension ratios improve from the prior year.1 Currently, most state and local government plans aren't at or above 100% funded levels. That means that—factoring in projected future investment returns relative to estimated future benefit costs, projected retirement dates for current employees, and other factors—they haven’t set aside all of the assets required to meet 100% of the needs of future retirees.
The level of funding doesn't show the whole picture, however. It's only a snapshot of the amount of assets available to invest in order to meet projected future needs.
To help determine if a pension is likely to be a longer-term problem, an important metric to evaluate is the state or local government's annual required contribution (ARC), or the amount it needs to pay to keep the plan on a steady path to full funding.
Any sign that a state or municipality isn't willing, or able, to make the contributions required each year to pay for future pensions costs is often a red flag of other budget problems. That’s one reason, according to rating agencies, for several recent state rating downgrades.
If a state or municipality fails to pay 100% of its ARC, it is pushing the expense into future years—which can become an overwhelming burden if payments are delayed for too long. The illustration below shows the percent of ARC paid in 2012.
The percentage of ARC paid varies drastically
Source: Pew Charitable Trusts, as of March 2014.
Rating agencies are beginning to take notice
Very few states have fully funded pensions, and very few have been able to make 100% of contributions actuarially estimated as necessary to them in recent years. Moody's downgraded Illinois, Connecticut, Kentucky, New Jersey, Hawaii, and Pennsylvania in recent years, citing (in part) their heavy pension exposure as one reason for the downgrade.2
In fact, Illinois was downgraded by Moody's five times since 2009 as a result of its growing liability—which is the worst in the nation—and other unpaid bills. Partly as a result, the additional compensation an investor requires for holding a 10-year Illinois general obligation bond is 155 basis points above the yield on a AAA-rated muni—the highest of any state.3
Not all the news is bad
For most municipal governments, not having 100% of the assets to meet a future liability isn't a grave concern on its own, or a sign of insolvency today. Most state and local pension plans "have sufficient assets to cover their benefit commitments for a decade or more," according to a report from the Government Accounting Office.4
Pension funding status
Source: Standard and Poor's, as of June 24, 2014.
Also, state pension contributions nationally account for approximately 7% of total taxes, so it appears most municipalities have the resources to adequately manage their current pension burdens, according to the Rockefeller Institute. However, this can vary from state to state.
Large pension liabilities force action
For the most part, states have shown a commitment to managing their pension burden. According to the Pew Charitable Trusts, 45 states have approved some version of pension reform since 2009. Also, more than 2,500 bills related to pension reform were introduced from 2013 through the first half of 2014, according to the National Conference of State Legislatures (NCSL).
The most effective reform tool appears to be reducing future benefits, which in turn cuts the amount the state has to pay today to fund that benefit. Reducing benefits for current employees can be constitutionally challenging, though. Other reforms are aimed at increasing employee contributions, raising taxes, or reducing spending. Some states are even moving away from a pension-type retirement plan and shifting new employees to a 401(k)-type retirement plan, effectively shifting the investment risk of funding the employee's retirement from the municipality to the individual.
What to do about it
The worst may be behind us in terms of funded pension levels. S&P's opinion is that although funded levels have continued to decline, they have likely bottomed out.5 But that doesn't mean you shouldn't pay attention. How should the issue change your approach to investing?
- Do your homework. Schwab clients can find recent disclosures and financial statements, which generally include the funded ratios for the issuer's pension plans, in the MuniDocs® on Schwab.com. Also consider qualitative factors. If you own state and local bonds, are government leaders tackling pension problems, or postponing action? If you own bonds from issuers that have been less proactive in addressing pension or other budget issues, you should generally receive higher yields in exchange for the higher risk.
- Diversify. If you own 10 or more individual issuers, at a minimum, the diversification helps limit idiosyncratic, individual credit risk. We don't expect to see a significant increase in defaults or distress caused by pension or post-employment costs. Try to avoid too much exposure to any single issuer, but if you do hold any outsize positions, we believe you should focus even more on the quality of those bonds.
- Consider munis that aren't affected by pensions. If you are concerned about rising entitlement costs, consider looking at munis that are not affected by pensions. For example, some munis are legally backed by a dedicated tax pledge as their source of repayment.
- Consider outsourcing to professionals. Investors without the desire and interest to monitor individual credit conditions are not alone. We believe professional muni bond fund managers can help manage issuer-specific risk and monitor issues—like pension liabilities.
How Are High-Yield Bonds Hurt by Falling Oil Prices?
As oil prices have fallen recently, so have prices of high-yield bonds. Are these events connected?
The answer is yes. While the sell-off in the high-yield bond market has a number of causes, such as rich valuations and declining demand from individual investors, we think the recent drop in oil prices has played a role as well.
Lower oil prices tend to hurt energy companies, which can in turn exert a drag on the overall high-yield market because of their sizable share of the market. Despite the recent drop in high-yield bond prices—and accompanying higher yields—we’re still cautious on high-yield bonds. We believe any further declines in oil prices could continue to put pressure on the high-yield market.
Energy companies have increased their debt
Oil prices can have a broad impact on the high-yield bond market because energy corporations have been increasing their share of the high-yield bond market. Today, energy companies make up more than 15% of the Barclays U.S. Corporate High-Yield Bond Index.6 That's up from less than 5% of the index at the end of 2005—and the chart below shows that the share has been steadily increasing over the past decade.
Energy companies make up a rising share of the high-yield bond market
Source: Barclays U.S. Corporate High Yield Bond Index. Columns represent the weight of the energy sector in the index. All columns represent year-end values, except 2014, which is as of October 17, 2014.
In fact, the energy sector now has the second-largest weighting in the high-yield bond index, trailing only the communications sector, which accounts for more than 18% of the index. At the end of 2005, the energy sector was only the seventh-largest weight in the index.
Total crude oil production is expected to average 9.5 million barrels per day in 2015, the highest amount since 1970, up from an average of 7.4 million barrels per day in 2013,7 according to the U.S. Energy Information Administration (EIA). With that expected increase in production, energy corporations have been borrowing money to expand their facilities and boost their output.
That boost in production may have made sense when oil prices were above $100, but recently they have fallen considerably—a decline of more than 20% —which means the earnings of many oil producers will likely be negatively affected.
Source: Federal Reserve Bank of St. Louis. Crude Oil Prices: West Texas Intermediate (WTI) – Cushing, Oklahoma (DCOILWTICO). Daily data as of October 14, 2014.
The decline in oil prices isn't the only negative factor for domestic energy companies. On average, cash flow has not kept pace with the cost of operations for most domestic oil producers. For the year ending March 31, the gap between cash from operations and uses of cash for 127 major oil and natural gas companies rose to $110 billion, a six-fold increase from the $18 billion shortfall in 2010, according to the EIA.
That shortfall has generally been met by the increase in corporate debt, as well as the sale of assets. While the sale of assets may boost the cash balance in the short-term, firms are likely giving up future cash flows from the loss of those assets.
Energy companies' poor performance
The energy sector has been the worst-performing sector of the high-yield bond market over the past few weeks.
From August 31 through October 20, the Barclays U.S. Corporate High-Yield Bond Index has generated a total return of -1.8%. Over the same period, the energy sector of the index performed even worse, falling 4.6%. While the energy sector posted the largest drop, almost all other sectors generated negative returns as well, so even a strategy that avoided, or limited, energy issuers would have likely performed poorly.
The energy sector is dragging down the rest of the high-yield bond market
Source: Barclays, sub-sectors of the Barclays U.S. Corporate High Yield Bond Index. Total returns assume reinvestment of interest and capital gains or losses. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.
Can't bond investors wary of lower oil prices just avoid the debt of energy companies? While that may be easy for investors who buy individual bonds, an investor in an index fund that tracks the high-yield bond market would likely have increased exposure to this sector. Actively managed mutual funds have the ability to underweight certain sectors and issuers, but they are still likely to have exposure.
Do high-yield bonds offer enough compensation for the risks?
Overall, we still have a cautious stance on the high-yield market in general. Although spreads and yields have risen over the past few months, we still don't think investors are being compensated enough for the risks involved in high-yield bonds.
The average option-adjusted spread (OAS) of the Barclays U.S. Corporate High-Yield Bond Index was 4.5% on October 20, up from the post-crisis low of 3.2% on June 23. A credit spread, or yield spread, is the amount of yield a corporate bond offers relative to a Treasury bond with a comparable maturity; it can be thought of as compensation for the increased risks that corporate bonds have compared to Treasuries. Based on historical data going back to 1994, the average OAS of the index was 5.2%, so it's currently below its long-term average.
We still think there is room for spreads to move higher. Since bond prices and yields move in opposite directions, a higher spread would negatively affect the prices of high-yield bonds. The last time high-yield bonds suffered a significant sell-off, during 2013's "taper tantrum," the average OAS of the index got as high as 5.1%, a level we think it could achieve in today's volatile environment.
A lot of investors who have been reaching for yield may still be in high-yield bonds. While high-yield bond funds have experienced significant outflows over the past few months, the chart below shows that a lot of money is still in the market. If investors continue to head for the exits, prices could fall even further.
Recent outflows are just a fraction of the net inflows since 2009
Source: Morningstar Inc. Lines represent the cumulative net flows into mutual funds categorized by Morningstar Inc. as "High Yield Bond" from January 2009 through September 2014, using monthly asset flows.
Oil price declines are just one more factor that can negatively affect the high-yield bond market. We are still cautious on high-yield bonds, as the low yields don't compensate for the increased risks, in our opinion. We still think investors who have been reaching for yield with high-yield bonds should move up in quality to investment grade corporate bonds.
3 Myths About Retirement Income Strategies
Investing for income in retirement is a challenge even for sophisticated investors. The path to a more secure retirement can be littered with stumbling blocks and pitfalls, and it can be hard to differentiate sound advice on retirement income strategies from red herrings.
Here are a few myths about retirement income strategies and how we think about them.
Myth # 1: You should invest for income only
The myth that yield is the most important factor in building your retirement portfolio is pervasive, and understandably so. It makes intuitive sense to favor investments that generate income when you shift from building assets to using assets to support you.
It's true that interest and dividends are predictable, and always positive—short of default of the issuer, or cancellation of a dividend. They're excellent building blocks for cash flow from a retirement portfolio. But we don't think they should be the only form of return. We suggest that you remain well-diversified, allowing you to reap different forms of return.
One problem with investing just for interest and dividends: Interest rates are low now, so the possibilities of generating enough income are limited. The temptation, then, is to reach out aggressively for yield, where you can find it. But this can be dangerous and unnecessary.
A second problem with investing solely for income: It's limiting, and can cost you the benefits of diversification or capital appreciation. For instance, historically speaking, growth-oriented investments tend to grow more than yield-oriented investments over time. And taxes on capital gains are often lower than tax rates on interest, a factor that impacts your after-tax income—unless you're invested in municipal bonds.
A broader approach uses interest, dividends, capital gains and stable principal. You then build an income plan based on all sources of return.
Once you're not focusing just on interest and dividends to meet your day-to-day expenses, you'll see that cash can be generated from your portfolio from periodic rebalancing, planned sales, or from short-term investments or maturing bonds. The trick is to withdraw enough to live on and leave your portfolio with the right balance of stocks (for continued potential growth) and bonds (for stability and income) while maintaining a comfortable risk level.
Most portfolios should include these three items:
- Short-term investments (for liquidity)
- Core investment-grade bonds (for diversification and income)
- Traditional equity (for income and growth)
In addition, depending on your income preference and risk tolerance, you might want to consider:
- More aggressive bonds (for higher income)
- Specialized equity (for higher income and growth)
Yield and historical volatility on selected income-oriented investments
Source: Barclays, Bloomberg. Index yield or representative rate as of October 27, 2014. Total return and volatility show annual 12-month rolling return and annualized standard deviation, using monthly returns October 2004 – October 2014.
Indexes shown are Citi Treasury Bill 3 Month, Ibbotson 1 Year Treasury Constant Maturity, Barclays U.S. Govt/Credit 1-3 Year, Barclays Municipal Bond, Barclays U.S. Credit, Barclays U.S. Corporate High Yield, BofA Preferred Stock Fixed Rate, FTSE NAREIT All Equity REITs, Alerian MLP, Ibbotson S&P 500, S&P 500 Dividend Aristocrats, S&P 500 Utilities, using monthly data and annualized returns and standard deviation from October 2004–2014. Yields as of October 27, 2014.
It is possible to find higher-yielding investments. But they come with different risks, and they are not necessary to fund retirement spending. Volatility is a technical term. But what volatility shows in the table above is how widely the value of a particular investment, represented by the indexes above, might move up or down in value in a single year. Note how volatile many of the sectors with higher yields have been. Take this into careful consideration when selecting investments primarily for investment income.
What to do now: Focusing on interest and dividends can make sense as the starting point of a retirement portfolio. But on its own it can be dangerous, and unnecessary. Yes, dividends have an opportunity to grow with inflation. Capital appreciation should be part of the mix to help boost returns as well. Use interest, dividends and capital gains and cash. This is a balanced approach.
Myth #2: Bonds are inherently better than bond funds
Many investors find CDs (certificates of deposit) and individual bonds to be useful investment tools for one major reason: They come with a specific maturity date. You know what you're going to get, short of default, and when you're going to get it.
Individual bonds, invested using bond ladders and other approaches are a great foundation for many portfolios. We like bond ladders for a lot of reasons. For one, they’re a great planning tool. They help you plan your income by returning a set amount of money to you both from interest payments and at maturity—without regard to whether the market is up or down.
But are they essential, or fundamentally "better" than bond funds? Not necessarily, in our view.
Depending on your portfolio size and preferences, bond funds can fill most of the needs often served by individual bonds. If you don't have the interest, time or resources to build a diversified bond portfolio, a collection of bond funds can do the job as well.
You give up a fixed maturity (with some exceptions) and add a fee. In exchange, you receive diversification, active management and relative simplicity. If you choose bond funds by the average maturity of the bonds within them, this is a relatively simple way to manage your time horizon as well.
What to do now: You can use bonds, or bond funds, as a foundation for a retirement portfolio. If you use bond funds, start with funds in the following Morningstar categories:
- Short-term bond funds
- Intermediate-term bond funds
- Multi-sector bond funds
Short-term funds are for needs in the next one to four years, intermediate-term funds are for needs in the next four plus years, and multi-sector (or high-yield) funds are for needs in the next four plus years with higher income potential. For more insight on how changing interest rates may affect bond funds, take a look at the article "Should You Worry About Bond Mutual Funds if Interest Rates Rise?"
Myth #3: Annuities are bad for you—and expensive too
Many types of annuities have a bad reputation, and potentially for good reason. They can come with high fees and "lock-ins." Certain types of annuities, however, if properly used, provide what other investments can't: insurance against several risks to your retirement income. The main risks annuities can help protect against are market volatility, susceptibility to negative returns, and longevity.
Can you manage all of these risks yourself? Possibly. But if you value protections, two types of annuities are worth considering: fixed immediate annuities, where you buy a stream of income, similar to what you would receive from a pension, and variable annuities with optional income protections (the most common of which is a guaranteed lifetime withdrawal benefit, or GLWB.) Many are expensive. But not all are. Here are the pros and cons of each.
Basic features of type of annuities for retirement income
Questions to consider
Variable deferred annuity with optional living benefit (such as GLWB)*
Fixed immediate annuity (SPIA)
What is it?
A variable annuity with a rider that provides income protections on a portfolio of investment funds held within the annuity.
An instrument providing pension-like income for life or a specified period of time.
When might it make sense?
When you want to stay invested but protect your retirement income against market risk by guaranteeing a minimum level of withdrawals annually, no matter how markets perform.
When you want to ensure you will have pension-like income for a set period or for life, either singly or jointly with your spouse.
Are there income guarantees?
The insurer generally guarantees a minimum annual withdrawal amount from the variable annuity for life.
The insurer pledges to make income payments that last for a fixed period or life.
Is it revocable?
Unless you annuitize the contract, you retain control over assets and aren’t required to turn over a lump sum irrevocably in exchange for income.
Irrevocable, with no liquidity after a lump sum is turned over to an annuity provider.
Is there market participation?
Annuity owner has potential to participate in market growth, after accounting for fees and withdrawals.
None. Annuity provider assumes market risk.
What are the costs?
Investment fees, insurance costs, and fees for optional riders charged annually.
Costs, such as mortality and expense charges and administrative fees, which are embedded in the up-front cost of purchase.
Source: Schwab Center for Financial Research.
Annuity guarantees are subject to the financial strength and claims paying-ability of the issuing insurance company. Optional living benefits, such as GLWBs, do not constitute a contract value, cannot be accessed like a cash value, and will not preserve your contract value which will deplete with each withdrawal.
*Living benefits are optional riders added, at an additional cost, to a variable annuity. A common type of living benefit is a guaranteed lifetime withdrawal benefit, or GLWB. A GLWB rider may protect against market downturns by guaranteeing a minimum amount of withdrawals from the portfolio annually, no matter how markets perform, without turning over assets irrevocably to the insurer.
Both of these types of annuities help do a simple, but useful, thing: pool the risks that you experience with others, such as the risk of living longer than average, of a down market right before you retire, or that you don't stick with your investment plan.
What to do now: Income protection, in the form of the guarantees and "risk pooling" provided by annuities can be good for your retirement health and confidence if you use low-cost annuities, with the right features, to support your income needs. Annuities can be complex, however. To learn more about how they might fit, talk with your financial advisor.
We hope our analysis of these three myths will help you get a better handle on what investing for income in retirement may look like. Keep in mind that there is never a single right answer. Think about your own needs and preferences, and put together the plan that meets your requirements.
I hope this enhanced your understanding of muni bonds and pensions, oil prices and high-yield bonds, and retirement income strategies. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)
1 Standard & Poor's, "U.S. State Pension Funding: Strong Investment Returns Could Lift Funded Ratios, But Longer-Term Challenges Remain," as of June 24, 2014.
2 Moody's Investor Services, "Pension Liabilities Among U.S. States Vary Widely," as of September 19, 2013.
3 Bloomberg, as of October 16, 2014.
4 GAO, as of March 2012 (http://www.gao.gov/assets/590/589043.pdf).
5 Standard and Poor's, "U.S. State Pension Funding: Strong Investment Returns Could Lift Funded Ratios, But Longer-Term Challenges Remain," as of June 24, 2014.
6 As of October 17, 2014.
7 "Short-term Energy and Winter Fuels Outlook," U.S. Energy Information Administration, October 7, 2014.
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Barclays U.S. Corporate Bond Index covers the USD-denominated investment-grade, fixed-rate, taxable, corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody's, S&P, and Fitch. This index is part of the U.S. Aggregate.
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