One of the games in town these days is selling structured
products to frightened people. Put together by young guys with horn-rimmed
glasses using a sack of securities and a Cuisinart, these products promise
investors floors, guarantees or reduced downside risk for a price. They're
huge moneymakers for investment banks.
Nobody has lost more money than pension funds over the
past three years, which makes pension-fund trustees the prime targets
for structured products. My partner and I ran into one last week that
I want to warn you about.
It's called defeasance, but should be called malfeasance
today. It's a time-honored tool for locking in yield when interest rates
are temporarily very high. It's a terrible tool now, when rates are
at rock bottom and sure to increase in coming years.
Resist the Temptation
Here's how the pitch goes. "I know (trustee's name here) that you
have lost a lot of money in the market over the past three years, and
you are worried (whisper the words "Sarbanes-Oxley" here)
about whether your pension fund will be able to meet its future legal
obligations to retirees. Your obligations are very predictable and very
long-term. What a prudent person like you needs today is a way to guarantee
that you'll be able to meet these obligations. Luckily, we have just
the thing for you." (Earnest smile here.)
"We have designed a structured product for you using
the latest quantitative techniques, invented by Nobel Prize winners,
that will take the risk out of your portfolio. We have modeled your
future cash obligations for each of the next 30 years. We have taken
the entire population of fixed-income securities available in the market
today and analytically 'stripped' them into individual cash coupons
that mature in specific future years. Then we used them as building
blocks to synthetically structure the optimal portfolio (pause here
for emphasis) of these individual coupons for your fund, with cash flows
that will exactly match your fund's liability stream. You will be able
to meet your obligations without subjecting your fund to any more of
that market risk that caused so much trouble."
Just Say No
The textbooks call this defeasance. According to the dictionary, defease
means to render something neutral. It was a great idea in 1981. It wasn't
a bad idea in 1999. It is a terrible idea today. Here are the reasons
why.
* Buy high, sell low: I first used defeasance as
a strategy for a public company in 1981. We were able to put together
a portfolio of coupons with yields of about 15%, match them against
a stream of existing obligations for retired workers in a pension fund
with a 9% actuarial yield assumption, hand both to a trustee, and voila,
create net worth on the balance sheet because the price we paid for
the securities was significantly lower than the present value of the
obligations.
But that was when rates were 15%. Today they're barely
visible. Today, the market will let you lock in a yield, but it's lower
than the total return assumption you're using for the portfolio. It
is the wrong time to lock in rates. You have already paid the tuition
in the bear market. Now you need to stay the course to collect the reward.
* Wrong time to reduce equity allocation: This
is a terrible time to sell out of the market. Taking this structured
product would be a de facto reduction in your equity allocation. Over
the next few years, stock prices will rise, but bond prices are likely
to fall as interest rates increase during the recovery. Hang onto your
equity allocation.
* Wrong securities: Equities more closely match the duration of
a pension fund than bonds. The duration of an equity portfolio is much
longer -- more than 20 years -- than the duration of even the long Treasury
bond. Equities are more closely matched with the duration of your liabilities.
You are actually increasing risk of mismatched duration by shifting
from equities to bonds.
* Wrong liability stream: Finally, it won't work anyway. Defeasance
only works for fixed liability streams, such as those attached to already
retired workers with fixed benefits. Most of your future pension obligations
are in the names of people who are still working. Their benefits will
rise with their incomes until they retire. Equities do a better job
of tracking these changes than bonds.
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