Companies that faced the biggest pension deficits ever last year are narrowing the gap at a record pace as gains in assets and a rise in corporate bond yields in March trimmed liabilities last quarter.
The deficit between the assets of the 100 biggest company pensions and projected liabilities shrank by $110 billion to $227 billion in the three months ended in March, the best first-quarter improvement since at least 2001, according to Milliman Inc., a Seattle-based actuarial and consulting firm.
Smaller funding gaps are helping to bolster sentiment in credit markets for companies from Alcoa Inc. to Textron Inc. that have some of the largest pension deficits. The average cost of protecting against their default has dropped more than five-fold this year relative to similarly rated companies. The best equity returns since 1998 in the first quarter helped narrow pension obligations and supported a move into fixed-income assets that provide more stable returns.
“As funded statuses improve, more plans are looking to take risks off the table” by shifting to bonds, said Zorast Wadia, a principal and consulting actuary with Milliman.
The companies in the firm’s index held 85.1 percent of their future payout to retirees at the end of March, up from 78.7 percent in December. For the first time last year, companies shifted to investing the majority of their assets in bonds rather than stocks, Zorast said.
Companies are digging out of deficits created by near-zero interest rates, which drive down the corporate bond yields that determine future pension liabilities. Lower rates mean they have to set aside more cash for future payouts to retirees.
The average cost of credit-default swaps on Alcoa, Textron, L-3 Communications Corp. and Owens Corning Inc., all of which Fitch Ratings says are funding about 80 percent of their pensions, fell to within 6 basis points of the average for a group of 37 companies with the same BBB- credit grade by the firm, prices compiled by Bloomberg and data provider CMA show. That’s down from about 34 basis points at the end of 2011.
Elsewhere in credit markets, Credit Suisse Group AG, Citigroup Inc. and Goldman Sachs Group Inc. are said to be teaming up to bid on $7.49 billion of commercial-real estate securities the Federal Reserve Bank of New York took on in the 2008 rescue of American International Group Inc. A benchmark gauge of U.S. company credit risk rose to the highest level in more than a week.
Credit Swaps Rise
The Markit CDX North America Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses on corporate debt or to speculate on creditworthiness, rose 2.3 basis points to a mid-price of 102 basis points as of 11:28 a.m. in New York, according to prices compiled by Bloomberg. The index is trading at the highest level since April 11, the day after it reached an almost three-month intraday high of 105.1.
In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings added 5.6 to 149.2.
The indexes typically rise as investor confidence deteriorates and fall it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a swap protecting $10 million of debt.
Bonds of Fairfield, Connecticut-based General Electric Co. are the most actively traded dollar-denominated corporate securities by dealers today, with 33 trades of $1 million or more as of 11:33 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Maiden Lane Bids
Citigroup, Credit Suisse and Goldman Sachs expect to distribute the group’s preliminary price estimates tomorrow on the commercial real-estate debt, composed of two collateralized debt obligations issued by Deutsche Bank AG in 2007 and 2008. Final bids are due on April 26 by 9 a.m. in New York, according to three people with knowledge of the auction, who declined to be identified because the negotiations are private.
The New York Fed invited eight broker-dealers to compete for the so-called MAX CDOs after receiving “several” unsolicited bids for the holdings in its Maiden Lane III LLC portfolio, according to an April 10 statement. The other banks invited to bid are Barclays Plc, Deutsche Bank AG, Bank of America Corp., Morgan Stanley and Nomura Holdings Inc.
After reaching a record $439 billion in September, pension deficits for the companies in Milliman’s index contracted every month in the first quarter.
L-3, Owens Corning
Funding levels were bolstered by a 5 percent gain in asset values, according to Milliman. The first monthly increase in corporate bond yields since November added another boost by lowering companies’ future liabilities. Yields on investment-grade bonds in the U.S. climbed 0.06 percentage point in March to 3.5 percent, according to Bank of America Merrill Lynch index data.
The discount rate rose 19 basis points last month, to 4.88 percent from 4.69 percent in February, Milliman said. That led to a deficit reduction of $58 billion for the month, the largest monthly gain in the first quarter, Wadia said.
Credit swaps on Alcoa, which reported $10.7 billion in pension obligations as of Dec. 31, dropped 91 basis points to 297 basis points this year through April 20, according to prices compiled by Bloomberg.
Contracts on L-3, which reported $2.7 billion, tumbled 37 to 164. Owens Corning, with $1.1 billion in obligations, fell 67 to 195, while Textron, which reported $6.3 billion in obligations, plunged 75 to 162, Bloomberg data show.
The average price for credit swaps on 37 companies with BBB- ratings from Fitch fell 40 basis points during the same period to 197, according to data from CMA.
Representatives for the companies declined to comment or didn’t return phone calls seeking comment. The pension obligations are taken from the companies’ 2011 annual reports and are calculated on the basis of generally accepted accounting principles, giving a different deficit amount compared with rules set by the Employee Retirement Income Security Act.
Companies with pension obligations have to contend with interest rates that have dropped back to record lows, said Mark Oline, an analyst with Fitch in Chicago. He’s expecting pension managers to boost payments to plans this year based on projections of corporate bond yields.
“They’ll have to make up the difference in increased contributions,” he said.
The discount rate is three times as important as investment returns in determining pension obligations, said Kenneth Hackel, president of CT Capital LLC in Alpine, New Jersey.
“The discount rate is the most important” and doesn’t appear headed upward, he said. “Economic growth is slow and half of Europe is in a recession. That does not bode well for the discount rate.”
Investment-grade corporate bond yields fell to a record low 3.392 percent on April 19 and ended the week at 3.403 percent, according to the Bank of America Merrill Lynch U.S. Corporate Master index.
As companies move closer to fully funding their pensions, they’re likely to continue to transfer assets into bond markets that provide more stability than stocks, Milliman’s Wadia said.
Equities accounted for 38.1 percent of invested assets in 2011 while fixed-income was 41.4 percent, he said.
The shift was “a major revelation” in the firm’s 2011 report on pension plans, Wadia said. The firm hasn’t published data on first-quarter asset allocation, he said.
Bonds Beat Stocks
U.S. corporate pension plans sold $24.8 billion of equities during the fourth quarter, and increased their fixed-income assets by $9.9 billion to $898 billion, according to data from the Federal Reserve Bank of New York. The fourth-quarter figure represents the largest sale of equities for corporate plans since the third quarter of 2010. First-quarter Fed data on asset purchases by pension plans is expected in June.
The move into fixed-income markets last year benefited asset returns as global investment-grade debt gained 5.2 percent in 2011 while the S&P 500 index of stocks increased 2.1 percent after reinvested dividends, according to the Bank of America Merrill Lynch index and data compiled by Bloomberg.
Corporate bonds in the U.S. are again outperforming stocks this month for the first time since December, gaining 0.8 percent compared with a loss of 2 percent for the S&P 500.
As more companies end their pension plans, they’re looking for the stable returns of the bond market compared with stocks, said Fitch’s Oline.
“Over time that can certainly de-risk the portfolio because you’re going to get less volatility,” he said. Pensions may have to accept lower returns for the strategy as they lock in historically low yields in credit markets now, he said.