Corporate Tax-Rate Changes Seen Adding to U.S. Duration Grab

  • Treasuries stand to gain from pension obligation funding
  • U.S. defined-benefit plans have been waiting on higher rates

Add another reason to the list of why yields on longer maturity U.S. bonds aren’t likely to rise very much this year even with the Federal Reserve boosting borrowing costs.

Companies seeking to get ahead of possible changes in tax rates are likely to be big buyers of Treasury bonds and zero-coupon-like securities as they seek to lock in the benefits of deductions in 2017 for pension contributions while addressing a funding gap estimated in the billions of dollars.

“In all likelihood, the proposed cut in corporate taxes will increase defined-benefit pension funds’ demand for duration,” said Ruslan Bikbov, U.S. rates strategist at Citigroup Inc., who estimates that U.S. corporations face a $600 billion funding gap in defined-benefit plans. “These funds will certainly then need to buy long-date duration,” a measure of how much bond prices move with changes in yields.

Pension fund contributions are tax exempt, so a lower corporate tax rate may mean that the benefit of such investments will be reduced. That may trigger a one-off wave of early contributions this year to boost benefits in case President Donald Trump does cut the corporate tax cut from 35 percent to 20 percent sometime next year -- possibly retroactive to the start of 2018, adds Bikbov.

Bloomberg analysis, seen in the graphic below of the EQS function, shows that of the 1,103 U.S. corporations that disclose information on their pension plans, about 1,013 currently have unfunded liabilities. General Electric Co. has the largest funding gap, measured in dollars.

The demand for duration has been clear in recent years, with the amount of Strips -- a favorite of the asset-liability manager community that pension funds are among -- jumping to a record in September. Strips have greater duration than their note and bond counterparts, meaning they usually suffer steeper losses when rates increase, and greater gains when rates fall.

One caveat is the view that rates are set to rise amid better global growth and monetary policy normalization, which may keep pension funds on the sidelines since higher yields naturally reduces funding gap by making the present value of liabilities decline.

“Still, some pension funds will make early contributions, and that will cause more duration demand,” given the possibility of a tax cut, said Bikbov. “A lot of pension funds have been basically waiting for higher rates for a long time.”

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