Bonds Captivate $16 Trillion of PensionsMatt Robinson
Bond buyers stung by the first losses in more than a decade can look to pension funds from companies such as Ford Motor Co. for a measure of redemption.
Ford’s $64 billion pension is piling into bonds to reduce risk and lock in higher interest rates after a surge in yields and the biggest stock gain since 1997 sliced its funding shortfall by about half. The second-largest American automaker, which boosted debt investments to about 70 percent of its U.S. plan assets last year from 55 percent in 2012, is now looking to boost that allocation to 80 percent.
“Companies are now getting on the bandwagon,” Ford Treasurer Neil Schloss said in a Jan. 9 telephone interview from the company’s headquarters in Dearborn, Michigan.
U.S. pensions, which control $16 trillion, shifted out of equities and into bonds in the third quarter at the fastest rate since 2008, data compiled by the Federal Reserve show. The plans were more willing to own stocks after the Fed dropped its target interest rate close to zero and pushed down yields to record lows with its bond buying to support the U.S. economy crippled by the financial crisis.
After the 30 percent rally in the Standard & Poor’s 500 Index brought the biggest corporate pensions on the verge of closing shortfalls for the first time since before the crisis, they’re now pouring back into fixed-income assets to lower risk as the Fed’s move to taper stimulus causes yields to rise.
Renewed pension demand may help temper further losses in bonds after debt securities from Treasuries to corporate debentures and emerging-market government notes fell an average of 0.31 percent last year in the first decline since 1999, index data compiled by Bank of America Merrill Lynch show.
Yields on benchmark 10-year Treasuries surged to 3.05 percent this month, the highest since July 2011 and more than double the record low of 1.38 percent set July 2012. The yield fell to 2.84 percent, a three-week low on an intra-day basis, at 12:24 p.m. in New York.
The selloff pushed up yields on the longest-maturing investment-grade company bonds, which pensions buy to fund future liabilities, by 0.82 percentage point last year to 5.33 percent. The annual increase was the first in five years and left yields at the highest level on a year-end basis since 2010.
“It’s a very large source of demand” from the pension funds, Jeffrey Gundlach, chief executive officer of DoubleLine Capital LP, which manages $49 billion, said in a telephone interview from Los Angeles. “It puts a ceiling on interest rates, particularly corporate bond rates.”
The cost of future payments to retirees is determined by an estimated interest rate based on corporate bond yields, known as the discount rate. As that rate rises, pension liabilities decrease, and vice versa.
Coupled with the surge in equities that bolstered plan assets, the 100 biggest U.S. corporate pensions narrowed their deficits by a net $319 billion, according to Milliman Inc., a pension advisory firm based in Seattle. The improvement was the biggest since Milliman began releasing the data 13 years ago.
The plans are now 95 percent funded, the highest since 2008. Funding fell as low as 77 percent in 2012 as stocks had yet to fully recover from the financial crisis and the Fed’s stimulus caused bond yields to plunge.
The deficit for Ford’s pension, which risked forcing the carmaker to seek a federal bailout in 2009, has plummeted to about $10 billion from $18.7 billion at the end of 2012. Ford’s shortfall also declined as increasing earnings helped the carmaker to make more cash contributions to its pension.
As companies close those gaps, more of their plans are buying bonds, which allows them to match liabilities and eliminate the risk of potential deficits.
“They’re taking more equity risk off the table” with fixed-income securities as their funding status improves, Zorast Wadia, an analyst at Milliman, said in a telephone interview. “Pension plans don’t want to give back the gains that essentially took over five years to accumulate.”
Public and private pension funds in the U.S. added $117 billion of debt securities in the three months ended in September on an annualized basis and sold $135 billion of equities, according to Fed data released on Dec. 9.
The disparity was the greatest since 2008 when comparing third-quarter data on an annual basis.
About 70 percent of companies with defined-benefit plans, or those that provide workers with retirement income based on employment length or salary level, may increase their share of long-term debt securities and other rate-sensitive investments by 2015, based on a November report by Towers Watson, a New York-based pension advisory firm.
Ryder System Inc., the U.S. truck-leasing company, is increasing the debt allocation in its $1.6 billion pension to about 45 percent this year from about 30 percent, Treasurer Dan Susik said in a Jan. 9 telephone interview.
“This is continuing to play out,” said Mark Ruloff, director of asset allocation at Towers Watson. “They didn’t switch it all in one day, so it’s going to get spread into the next year and perhaps the next couple of years.”
Higher rates helped lower pension expenses at St. Paul, Minnesota-based 3M Co., which sells products as varied as Scotch tape and dental braces, to as low as $100 million from $534 million in 2012, the company said last month.
After suffering its worst pension deficit in nine years in 2011, 3M’s funding status has improved to 93 percent.
Deutsche Bank AG forecasts that pensions will sell about $150 billion in equities this year to buy corporate bonds due in 10 years or more. The debt outperformed notes with the shortest maturities last quarter by the most in a year, with the longest-dated bonds returning an extra 1.6 percentage points.
Bank of America, which predicted that investors would start abandoning bonds for stocks last year in what the Charlotte, North Carolina-based bank dubbed the “Great Rotation,” now anticipates investment-grade corporate bonds will return 1.6 percent this year, double its projection in January.
The advance would help restore last year’s 1.5 percent loss, the first decline since 2008, based on the Bank of America Merrill Lynch U.S. Corporate Bond Index. Yields have risen as the Fed pares its monthly debt purchases starting in January to $75 billion from $85 billion.
The central bank will cut buying by $10 billion in each of the next six meetings before ending its stimulus in December at the latest, according to the median forecasts of 42 economists surveyed by Bloomberg on Jan. 10.
Equities are also the most expensive versus Treasuries since 2011. The earnings yield for S&P 500 companies, measured by profits as a percentage of the index’s price, was 2.9 percentage points higher than the yield for 10-year government notes, the smallest premium since March 2011.
“You’re going to see a significant shift” from pensions into bonds, Rick Rieder, the co-head for Americas fixed income at BlackRock Inc., which manages $3.86 trillion, said in an interview at Bloomberg’s headquarters in New York. “It makes a ton of sense. Now that they’re funded, they can buy long-dated bonds” to lock in gains from their equity stakes.
With the longest-dated investment-grade notes already yielding the least relative to U.S. government debt since 2007, pension demand alone won’t be enough to keep bonds from falling out of favor, according to Marc Pinto, the head of corporate-bond strategy at Susquehanna International Group LLP.
The 1.6 percent return that Bank of America forecasts for notes issued by the highest-rated companies this year wouldn’t even be enough to compensate for a 1.7 percent increase in U.S. living costs that economists estimate in a Bloomberg survey. In 2012, investment-grade bonds surged 10 percent.
“It’s going to be difficult to eke out a positive total return in the investment-grade market in 2014,” Pinto said in an telephone interview. “The Fed is likely going to increase its tapering efforts and all of this will likely push long-term rates higher. That could pressure long-term returns.”
Short-term losses arising from an increase in yields may not deter pension funds as long as they can buy enough bonds to match their obligations as stricter regulations are enforced.
Under the federal Pension Protection Act, which was passed in 2006 and started to take effect in 2008, companies have seven years to fully fund their retirement plans and are required to use a specified, market-based rate of return to compute liabilities rather than their own forecasts.
“We, inherently as it relates to the pension plan, won’t care” if yields rise once we’ve bought a bond to match a specific pension liability, Ford’s Schloss said.
Instead, each 1 percentage-point increase in the discount rate used by Ford’s pension would cut its projected U.S. liabilities by $5.2 billion, its regulatory filing shows. Its weighted-average U.S. discount rate stood at 3.84 percent at the end of 2012, its annual filing showed.
Insurers are also poised to step up their bond buying as companies seek to offload plans. MetLife Inc., the largest U.S. life insurer, estimates that pensions have $800 billion in liabilities that may be transferred to insurance companies.
NCR Corp., the maker of automated teller machines, moved more than a $1 billion of retirement benefits to Pension Insurance Corp., a U.K. insurer, in November.
The Duluth, Georgia-based company, which started in 1884 by selling mechanical cash registers and now has about 26,000 employees, also shifted almost all its U.S. plan assets into fixed-income securities, according to John Boudreau, NCR’s treasurer. As recently as 2010, bonds accounted for as little as 30 percent of the pension’s assets.
“There’s a lot of natural demand for bonds as rates rise even modestly from here,” Ed Keon, who helps oversee more than $100 billion at Prudential Financial Inc.’s Quantitative Management Associates, said in a telephone interview.