Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Traditional investing logic would indicate that the rally in bonds is overdue for a reversal, but investors may have to continue to wait for any such turn.

They can thank or blame pension funds, depending on their perspective. These funds now oversee more than $18.6 trillion, a volume of assets that's bigger than annual U.S. economic output, according to Federal Reserve data. And they're increasingly plowing their money into debt, including money newly raised through increased taxes.

Stuffed Pensions
Public and private pensions now oversee a greater amount of assets than the U.S. economy
Source: Federal Reserve
2016 data is through the second quarter

These plans have generally reduced their assumed annual returns for the decades ahead, but many are still expecting unrealistically high rates of income. Instead of lowering their forecasts even more and requiring higher contributions from workers, they're investing in increasingly speculative assets, including more corporate and private debt. 

Bond Buyers
Pensions have steadily increased their holdings of corporate and foreign bonds in recent years
Source: Federal Reserve
2016 data is through the second quarter

"They invest based on their need to earn 7.5 percent, not on the fundamentals," Brian Reynolds, chief market strategist at New Albion Partners, wrote in a note on Friday. "They are bringing in more money than ever and allocating it to credit."

In fact, pensions have been directing more of their money to credit funds at an accelerating pace, pouring hundreds of millions of dollars into private debt funds, Reynolds noted in the report. 

Pensions, and insurance companies that mimic them, have accounted for about half of the growth in credit during this cycle, according to Reynolds. Not only that, but some municipalities have started raising taxes to increase contributions to existing plans -- new money that may just flow into already expensive markets. 

Taking a step back, it's important to recognize that this is not a new dynamic. This has been going on for a few decades and helped underpin average annual returns of 6.5 percent on U.S. corporate bonds since 1996.

But it's also a dynamic that isn't going to disappear quickly. What would make these pensions withdraw their cash from company bonds? Hard to say. Perhaps an inverted yield curve could put a dent in it because both traditional and nontraditional financial systems suffer when longer-term rates are lower than short-term ones. This could disrupt current channels of credit creation, causing a pullback. In the meantime, however, Reynolds just sees the credit boom gaining speed and continuing to fuel share buybacks that have driven stock gains.

How Low Can They Go
Companies have sold trillions of dollars of debt as their borrowing costs dropped
Source: Bloomberg Barclays US Agg Corporate Yield To Worst

While this dynamic supports values in the $8 trillion U.S. corporate credit market in the near future, it is lamentable in the long run. It encourages companies to sell debt for less-prudent endeavors. And it further discourages investors from scrutinizing specific companies' business models, with active fund managers generally underperforming the broad-based melt-up in riskier asset values.

As is, companies are incurring debt much faster than they're increasing their profits. Nations are borrowing money for a half century or more. The global debt load just keeps ballooning.

But the longer this game continues, the more risk builds in the system and the broader the pain when it all comes crashing down.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net