September 2, 2014

Bond Market Surprises

There is no substitute for mental preparedness. Just ask any professional athlete or Navy SEAL. One essential aspect of metal preparation is situational awareness - being able to identify, process, and understand what is happening around you at any given time.

That's been a challenge for bond investors this year. 2014's Treasury market rally took economists (and everyone else) by surprise:

"Treasury yields lurched higher in May 2013, when the Fed first sketched out a timetable to wind down its bond-buying program, even though it didn't actually begin the winding down until seven months later. Yields were expected to keep rising this year as that program ended and the Fed turned its attention to raising its short-term policy rate but, instead, yields have fallen as investors still seem enamored of bonds."

A Bloomberg survey (August 8-13) found economists' median forecast projected 10-year Treasury yields would be 2.7 percent by the end of September. The yield on 10-year U.S. Treasuries finished last week at 2.34 percent.

It's likely bond market surprises may continue during the next few months. In fact, bond investors may want to mentally prepare themselves for a rough and bumpy ride. It's likely analysts and investors will try to anticipate the Federal Reserve plans for increasing interest rates, and it's not all that hard to imagine the type of volatility that could ensue. All you have to do is think back to the ups and downs that punctuated guesses about when the Fed might begin to end its bond-buying program.

Barron's offered the opinion the first rate hike won't happen until March of 2015, but that won't stop anyone from speculating it could happen earlier. Conjecture, rumor, and supposition are likely to begin before the Federal Open Market Committee meeting on September 16, 2014.

No matter how markets twist during the next few months investors should keep their wits about them. Being mentally prepared may help.

Longevity Risk

Life expectancy has been increasing by 15 minutes every hour for the last 50 years or so in the richer countries around the world, according to The Economist. That's an increase of about 2.5 years per decade.

Longer lifespans are a mixed blessing. On the one hand, people may enjoy longer lives. On the other, the longer people live, the greater the chance that longevity risk - the possibility that life expectancy will exceed expectations - could negatively affect people, companies, and governments around the world.

One way to measure longevity risk is by estimating the cost of an aging society. The International Monetary Fund's (IMF) 2012 Global Financial Stability Report calculated the potential cost of providing everyone in the world, age 65 and older, with the average income necessary to maintain his or her standard of living at its preretirement level. By 2050, assuming a replacement rate of 60 percent of preretirement income, the cost would be about 11.1 percent of gross domestic product (GDP) in developed economies and 5.9 percent of GDP in emerging economies - and that doesn't include increases in health and long-term care costs. If longevity increases by three years, the estimated costs go up by almost 50 percent!

Insurance companies, employers with defined benefit (DB) pension plans, and governments are exposed to significant longevity risk. Insurers offer products designed to provide lifetime income. Employer-sponsored DB plans promise lifetime payments to employees who meet specific criteria. Governments with pension programs have made similar promises to citizens.

Many entities are looking for ways to effectively reduce their exposure to longevity risk. One way to manage longevity risk is to share it. An example would be to develop a "liquid longevity risk transfer market" where,

"...The "supply" of longevity risk would meet "demand" for that risk. That is, the risk would be transferred from those who hold it, including individuals, governments, and private providers of retirement income, to (re-) insurers, capital market participants, and private companies that might benefit from unexpected increases in longevity (providers of long-term care and healthcare, for example). In theory, the price of longevity risk would adjust to a level at which the risk would be optimally spread through market transactions. "

The overall longevity risk market could be sizeable. According to Risk.net, current global annuity and pension-related longevity risk exposure is between $15 trillion and $25 trillion.

Weekly Focus - Think About It

"Some cause happiness wherever they go; others whenever they go."

—Oscar Wilde, Irish writer and poet

Best regards,
Sean M. Dowling, CFP, EA
President, The Dowling Group Wealth Management