Views from the LDI desk: Winter 2025 markets commentary

2024 was a year characterized by higher rates, steeper yield curves and risk market outperformance. The higher rate environment may continue in 2025, though with elevated rate volatility, stemming from uncertainties around economic data and policy outcomes. While rates market dynamics have changed dramatically from when we wrote our Summer 2024 markets commentary, higher rates provide an even more attractive entry point for LDI investors to hedge interest rate risk.

Rates market

While 10yr treasury ended the year 70bps higher over the year, it was certainly not a one-way move; rates rose into April, then fell almost 1% into September. Despite the Federal Reserve (Fed) cutting interest rates by 100bps between September and December, the 10yr treasury rose by 77bps in the fourth quarter.

10yr Treasury Yield

Several reasons explain why rates have sold off by this scale since the Fed initiated the cutting cycle. First, rate cuts were already priced into the market coming into September, leaving little room for surprise in the form of rates coming down further. In addition to this, the election probability increasingly skewed towards a Trump win in the fourth quarter, with policy implications of tariffs and fiscal spending concerns resulting in higher expected inflation and term premium, respectively. Adding to the pressure, inflation prints also continued to come in higher than expected, remaining above the Fed’s 2% Core Personal Consumption Expenditures (PCE) price target, with shelter, used autos and services inflation remaining sticky.¹

In addition to higher rates, the yield curve has normalized from an inverse shape that has characterized rates market for much of the last few years. In 2024, the 2yr treasury was just 2bps higher from 4.23% to 4.25%. However, the 30yr treasury was 75bps higher from 4.03% to 4.78%, taking the 2s30s curve from -20bps to +53bps. This was a normalization of the inverted curve we have seen since 2022, as term premium has returned to the market. In an environment of non-parallel curve shifts, key rate duration hedging becomes especially important for LDI investors.

Treasury Yield History

Risk markets

Conversely, risk assets had a relatively smooth ride higher, absent a small downturn in early August. The S&P500 index returned 25% in 2024, exhibiting a positive return in every month except April and August.² Corporate credit spreads grinded 15bps tighter by end of the year, as measured by the Bloomberg Long Corporate Index, despite starting the year at already tight levels.

There were several supportive factors for corporate credit in 2024, including higher overall yields, strong economic growth and positive earnings momentum, resulting in consistent inflows to the asset class. Within the investment grade spectrum, compression played out as BBB-rated bonds outperformed A-rated bonds; BBB rated bonds within the Long Corporate Index were 21bps tighter, while A-rated were 11bps tighter and AA-rated bonds were only 3bps tighter.³ Pension plans investing in broad IG indices will likely have seen higher spread returns compared to their discount rate, which is typically comprised of high-quality corporate bonds (AA or A and above).

Long Corporate Index Spread

Implications for LDI Investors

Overall, we estimate that these factors combined resulted in higher funded status for the average corporate pension plan. Liability values likely declined from higher long-end rates while many plan assets with sizable equity market allocation likely benefited from higher valuations. We estimate funded status values rising 5.7% in 2024 to close out the year at 107.1%.

Funded Status Time Series

Looking ahead, the consensus is for interest rates to remain higher for longer, with considerable uncertainties. This provides an attractive entry point for pension plans looking to implement an LDI hedge or to increase their current interest rate hedge ratio.

With pension plans often reaching for overall duration by over-hedging to the long end and under-hedging to the front end of the yield curve, policy uncertainty and nonparallel curve moves are important considerations to keep in mind. Through our capabilities and experience, BlackRock’s LDI team can partner with clients to design and implement bespoke solutions that not only target overall duration levels, but also at each key rate duration buckets.

Plans may also be capital constrained and desire to keep a sizeable allocation to growth. In these scenarios, we recommend prioritizing the rates hedge over the credit spread hedge, as we expect the credit spread to remain a small proportion of the discount rate, particularly as interest rates remain higher for longer. For mandates that allow it, derivatives can make a welcome addition to improve hedges in a capital efficient manner.

Average funded status ratios continue to rise, making it as important as ever to have the right hedge on and protect the gains in funded status that have been achieved in recent years. It’s time to keep that funded status ‘higher for longer’ as well.