For some of America’s biggest bond buyers, the soft-versus-hard-landing debate on Wall Street might be a sideshow. They’re getting ready to swoop in with as much as US$1 trillion ($1.31 trillion), no matter what happens.
One of the pillars of the trillion-dollar pension fund complex is now awash in cash after struggling under deficits for two decades. This rare surplus at corporate defined-benefit plans, thanks to surging interest rates, means they can reallocate to bonds that are less volatile than stocks — “derisking” in industry parlance.
Strategists at Wall Street banks including JPMorgan Chase & Co., Bank of America Corp. and Wells Fargo & Co. say the impact will be far-reaching in what’s already being coined “the year of the bond.” Judging from the cash flooding into fixed income, they’re just getting started.
“The pensions are in good shape. They can now essentially immunize — take out the equities, move into bonds and try to have assets match liabilities,” Mike Schumacher, head of macro strategy at Wells Fargo, said in an interview. “That explains some of the rallying of the bond market over the last three or four weeks.”
An irony of pension accounting is that a year like last year, with its twin routs in stocks and bonds, can be a blessing of sorts to some benefit plans, whose future costs are a function of interest rates. When rates climb, their liabilities shrink and their “funded status” actually improves.
The largest 100 US corporate pension plans now enjoy an average funding ratio of about 110%, the highest level in more than two decades, according to the Milliman 100 Pension Funding index. That’s welcome news for fund managers who suffered years of rock-bottom interest rates and were forced to chase returns in the equity market.
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Now, they have an opportunity to unwind that imbalance and Wall Street banks pretty much agree on how they’ll use the extra cash to do it: buying bonds, and then selling stocks to buy more bonds.
Already this year fixed-income flows are outpacing those of equity funds, marking the most lopsided relationship since July.
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How much of that is due to derisking by pension funds is anyone’s guess. Some of the recent rally in bonds can be ascribed to traders hedging a growth downturn that would hit stocks hardest.
But what’s obvious is their clear preference for long-maturity fixed-income assets that most closely match their long-dated liabilities.
Pension funds need to keep some exposure to stocks to boost returns, but that equation is changing.
Once a corporate plan reaches full funding, their aim is often to derisk by jettisoning stocks and adding fixed income assets that line up with their liabilities. With the largest 100 US corporate defined benefit funds riding a cash pile of US$133 billion after average yields on corporate debt more than doubled last year, their path is wide open.
With yields unlikely to go above their peak level once the Federal Reserve hits its terminal rate of about 5% around the middle of the year, there’s rarely been a better time for them to make the switch to bonds.
Even if growth surprises on the upside and yields rise, causing bonds to underperform, the incentive is still there, said Bruno Braizinha, a strategist at Bank of America.
“At this point and considering where we are in the cycle, the conditions are favourable for de-risking,” Braizinha said in an interview.
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JPMorgan’s strategist Marko Kolanovic estimates derisking will lead pension managers to buy as much as US$1 trillion of bonds; Bank of America’s Braizinha says a US$500 billion buying spree is closer to the mark.
“The pattern has certainly been the shift from equities to fixed income,” said Zorast Wadia, principal and consulting actuary at Milliman and co-author of the pension funding index. “If you were even considering the merits of this in the past, now it’s a slam dunk. You certainly want to do it now.”
Achieving an asset-liability match has been a long-held goal for corporate defined benefit pension plans. Since 2008 they’ve cut their allocations to equities to about 29% from about 44%, in turn increasing fixed-income to about 51% from around 42%, according to the latest data from Milliman.
Pensions funds reach overfunded status when assets exceed the value of liabilities. For corporate plans, the interest rates on high-quality bonds determine the plan’s “discount rate” — an indication of what they expect as their risk-free return.
Thanks to the Federal Reserve’s aggressive interest-rate hikes, this rate surged to 5.22% as of Dec. 31, up from 2.8% a year earlier, according to a Milliman gauge.
Even as markets suffered their worst year since the financial crisis, corporate plans reaped a windfall as aggregate liabilities fell by US$493 billion, more than enough to offset investment losses of US$321 billion.
It’s a different story for public pension funds. They are more sensitive to swings in market prices. Unlike corporate defined plans, their funding ratios have fallen with falling markets.
For corporate pension plans, liabilities are based upon a corporate bond yield curve, making the performance of equities and bonds less relevant for the funding status.
If pension fund managers increase their allocation by 3% to 4% it would translate into US$1 trillion of bond purchases, according to JPMorgan calculations. Even a 6% increase isn’t out of the question, according to the firm’s strategists.
“This represents a unique and urgent opportunity for these funds to lock in the favourable funding status by selling equities and buying bonds,” Kolanovic wrote in a note. He described it as a “likely inflection point for equities to go lower and bonds higher.”