This shift in Fed policy will affect the ability of pension funds' fixed-income assets to achieve targeted funding levels, especially if those assets are managed relative to a high-quality benchmark such as the Barclays Aggregate Bond Index.¹ Accordingly, there also may be a partial shift away from high-quality, fixed-income benchmarks and toward credit-sensitive strategies that are more aligned with Fed policy objectives.

By tying its large-scale asset purchases to labor market conditions, the shift in Fed policy seems destined to keep the yields of high-quality securities near historically low levels for the next few years. Based solely on the scope of $40 billion in monthly purchases of agency mortgage-backed securities (MBS), the Fed's latest policy could mean that it adds to its balance sheet at least $1.1 trillion in agency MBS by 2015.² The total expansion of the balance sheet would likely be even higher given the extension of Operation Twist until the end of 2012 and the Fed’s suggestion that it could "undertake additional asset purchases" if the outlook for the labor market does not significantly improve.

Fed policy, specifically a third round of quantitative easing (QE3), now directly affects the benchmarks that drive fixed-income performance of many institutional portfolios. Indeed, the culmination of the Fed's quantitative-easing initiatives expands the central bank's influence into asset classes that comprise about three-quarters of the Barclays Aggregate Bond Index. (See Chart 1.) Further, the dominant representation of these asset classes in the benchmark index is likely to remain high or possibly increase going forward.

In terms of agency-related securities, their weighting in the index should remain elevated well into the future. This is because nearly all the financing for the housing market is now provided by Fannie Mae, Freddie Mac, and Ginnie Mae,³ given that financing from the non-agency residential securitization market has essentially ground to a halt. Issuance of agency securities could increase even further if the latest reduction in mortgage rates via QE3 generates more home-buying activity. In terms of the representation of Treasury securities within the index, the United States is likely to continue running significant deficits and require substantial debt financing for the foreseeable future.

As the Fed has expanded its balance sheet and its large-scale purchases across government-related asset classes, the yield of core fixed-income benchmark indexes has dropped precipitously. For example, before the introduction of the first round of quantitative easing in late 2008, the yield on the Barclays Aggregate Bond Index was 5.68%. And after the introduction of QE3, the yield had tumbled to 1.61% as of late September 2012. Although further expansion of the Fed's balance sheet has the potential to push core yields even lower, a yield of 1.61% or less is likely to increase the difficulty of institutions’ asset-liability processes, particularly those institutions maintaining funding assumption rates of close to 8%.

When the Fed does start removing some of its policy accommodation, we may expect a different market reaction than has been seen during previous periods of tightening monetary policy. Rather than raising the fed funds rate and flattening the Treasury yield curve, the Fed will likely stop large-scale asset purchases before selling existing securities from its portfolio. Such a process could lead to a meaningful increase in long-term interest rates and, with fed funds between zero and 25 basis points (bps), a much steeper Treasury yield curve. While a steeper yield curve could eventually generate yields that might improve institutional funding ratios, the process seems certain to expose high-quality and long-term holdings to a heightened level of market volatility.

Thus, the Fed's pursuit of low interest rates on high-quality bonds could aggravate pension-funding shortfalls to the extent that those assets underachieve targeted returns for several years. Subsequently, as quantitative easings are eventually unwound, the yield curve will likely steepen from the long end, pressuring bond prices lower and further aggravating funding shortfalls. Such consequences may force some institutions to consider a "go anywhere" strategy that grants asset managers the discretion to choose asset classes less affected by Fed policy and other variables. Meanwhile, other institutions may seek greater flexibility by moving a portion of their core fixed-income allocations into credit-sensitive strategies as they pursue their funding assumption targets.

Strategies that could complement a reduced core bond allocation include high-yield bond, leveraged loan, and short-duration, credit-sensitive strategies. For institutions considering a scenario where the Fed is highly successful in reviving the labor market, the economy, and possibly the rate of inflation, they may also consider equity strategies.

Based on yield alone, the 6.62% yield on the benchmark high-yield bond index and the 5.91% yield on the benchmark leveraged loan index as of September 30, 2012, may offer some enticement as institutions seek ways to achieve an 8% funding target. In addition to such relatively attractive yield, there also may be further capital-appreciation opportunities, particularly in high-yield bonds. While high-yield credit spreads have reached their long-term average of about 600 bps over Treasury yields, spreads have tightened close to the 300 bps in prior credit cycles. And the current credit fundamentals continue to remain sound, as evidenced by historically low default rates and attractive ratios of credit rating upgrades to downgrades.

The yields on leveraged loans may be lower than those on high-yield bonds, but this asset class may provide opportunities as well. In the event that short-term interest rates rise, the yields on these assets could increase accordingly. Given the adjustability of the yields on leveraged loans, the assets have minimal durations; they could, therefore, experience relative stability in periods of interest-rate volatility. The potential for relative stability during interest-rate turbulence and improved prospects to meet established funding assumptions might also apply to a short-duration strategy comprised of credit-sensitive instruments.

With decades of historical precedent, many institutions have constructed their fixed-income allocations around core bond strategies, an allocation to which may still be relevant if institutions have concerns about deflation and/or quantitative easing fails to achieve its objectives. Yet, the funding landscape has transformed with the extending influence of monetary policy across the most widely used fixed-income benchmarks.

The likelihood that this influence could extend further indicates that institutions may adjust to the ongoing transformation by complementing their core fixed-income allocations with strategies that may continue to benefit from the changing landscape, thus improving the prospects of meeting funding assumptions in what may be a challenging environment for at least the next several years.