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Fixed-Income Insights

Pension funds looking to "de-risk" their portfolios might be expected to snap up Treasuries at a faster pace. That hasn't happened—yet.

 

In Brief

  • A more than 50-basis point decline in the yield on the 10-year U.S. Treasury note has been attributed to a sluggish U.S. economy and tame inflation.

  • Market watchers may point to another potential factor: increased buying of Treasuries by U.S. pension funds eager to better match their assets to their future liabilities—and reduce funding uncertainty.

  • But while such a shift may make sense, given current market and regulatory conditions, recent data on changes in pension-funding ratios in 2014 and asset-allocation changes during 2013 suggest pensions may be making fewer fixed-income purchases than expected. 

  • The key takeaway: The "de-risking" moves by pension funds that were thought to have bid up the price of long-term Treasuries may yet unfold, but probably not at current interest rate levels.

 

What’s behind the decline in longer-term U.S. Treasury yields since the beginning of 2014? A sluggish U.S. economy and tame inflation have been widely cited in the financial media as causes for a year-to-date (through May 30) decline of more than 50 basis points in the yield on the 10-year U.S. Treasury note, based on Bloomberg data. But there is one other factor that bears watching: indications of increased purchases of Treasuries by pension funds.  If this preference for U.S. government debt is indeed a driving force behind the decrease in yield and the associated rise in prices of longer-maturity Treasury issues, it would represent a behavioral change among investors that was not apparent during 2013. Last year, for example, the yield on the 10-year Treasury rose, from 1.6% in May to 3%, by year-end, based on Bloomberg data. 

Understanding the rationale for this sudden preference for longer-term Treasuries is important to understanding the performance of 10-year Treasuries in 2014, year to date. Given the size of the U.S. pension market, the rationale could be even more important as a key influence on interest rates in coming years.

Two factors appear to dominate any shift among pension funds toward longer-maturity bonds, particularly at the end of 2013: funding status (that is, the extent to which current plan assets can cover future liabilities) and new government pension regulations. 

Funding Factors
Funding status is largely driven by the cost of funding pension liabilities and growth in assets to fund those liabilities.  In 2013, markets combined to reduce both the assumed cost of funding liabilities and improve pension fund asset growth at the same time.  Rising interest rates allowed pension funds to assume a higher interest rate to discount the cost of funding liabilities.  According to consulting firm Milliman, at the end of 2013, pension plans were able to use a discount rate of 4.75%, instead of 4.04%, which it was at the beginning of the year, thereby noticeably reducing the present value of assets needed to fund liabilities.

At the same time, the strong returns in U.S. equity markets in 2013—including a 30% advance for the S&P 500® Index, according to Bloomberg—allowed significant appreciation of pension assets.  According, again, to Milliman, the combined impact of rising interest rates and outsized equity returns appeared to shift the average funding status of the 100 largest pension plans, from 77.2% funded at the end of 2012 to 95.2% funded at the end of 2013.

Companies are understandably anxious to eliminate the uncertainty of funding status, and to mitigate the balance sheet and income statement impact from shifting interest rates and volatile stock markets. It might not be surprising that companies would choose to reallocate funds to long-term fixed-income assets at the beginning of 2014, to match, essentially, their future liabilities—and to reduce funding uncertainty.

The Match Game
Recent pension regulation also provided incentive for this behavior.  The Bipartisan Budget Act of 2013 (signed by President Obama on December 26, 2013), for example, includes higher premiums to the primary U.S. pension-fund insurer, the Pension Benefit Guarantee Corporation (PBGC), beginning in 2015. Companies pay premiums to the PBGC based on the amount their plan is underfunded. The 2014 premium of $14 per $1,000 of underfunded vested benefits will be increased by $10 for 2015 (to at least $24) and $5 for 2016 (to at least $29).  Both represent increases over previous planned premiums.

Thus, markets combined to create the opportunity for plans to secure a more fully funded status (and to reduce volatility) by shifting to assets, such as long-term bonds, that align with liabilities, while recent PBGC premiums provided economic incentive.  But to what extent did plans respond to both carrot and stick?  Verifiable numbers are not available, but inferences drawn from Milliman data on changes in funding ratios so far in 2014 and asset-allocation changes during 2013 suggest that pensions’ de-risking via fixed-income purchases may be less than expected. 

To start, the aggregate funding level was not as high as was estimated at the beginning of the year.  In April, Milliman reported that the overall 2013 year-end funded status for the 100 largest corporate pension plans, initially estimated to be 95.2% in January 2014, was in fact closer to 88% after all annual data were collected and analyzed.  The lower funding ratio may have provided less incentive for pension plans to de-risk portfolios through reallocation to Treasuries than was originally thought.  This wider funding gap could instead cause pension funds to postpone bond purchases. Why? Because they may hope that their funding status will improve during 2014 as a result of continued attractive equity performance and/or higher interest rates that might further reduce the assets required to meet liabilities. 

If pension funds had hedged liabilities at the beginning of 2014 by purchasing longer-dated Treasuries or corporate bonds, the decline in interest rates thus far in 2014 would have produced little change in funding status.  Instead, the fact that funding ratios declined to 84.7% during the first four months of the year, according to Milliman, suggests that a significant number of pension plans in the Milliman survey opted not to match liabilities. 

Allocation Shifts
This is not to say there was no reallocation to long-term bonds.  Indeed, the popularity of liability-driven investing (LDI) suggests that some funds, perhaps those that were better funded than the 88% average at the beginning of 2014, may have de-risked their portfolios by purchasing longer-maturity bonds at some point.  However, this strategy does not seem widespread.  In fact, if LDI had been increasingly embraced by the pension fund community, the allocation to fixed income would have increased during 2013 as plans took advantage of rising rates and strong equity performance throughout the year. 

Instead, the opposite happened.  Milliman reports that within its survey of the 100 largest pension funds, the allocation to fixed income was 39.6% at the end of 2013, compared with 40.4% at the end of 2012.  Such information suggests that LDI investing is not widely exercised and that the decline in interest rates, particularly the decrease in the 10-year Treasury yield, may be less related to pension fund purchases and more a function of other factors, including global disinflation, perceived slowdown in global growth, and increased geopolitical risk.

However, the de-risking behavior and associated demand for long bonds that was believed to have bid up the price of long-term Treasuries may yet unfold, but probably not at current interest rate levels.  The 4.75% discount rate that could be applied to pension liabilities at the beginning of the year had moved to 4.20% by the end of April, according to Milliman.  Those pension plans that missed an opportunity to match liabilities earlier in the year may be poised to shift assets if they get a second chance, but at current yield levels, it is now impractical. 

Investment Implications
Furthermore, other plans whose funding status fell short of 100% at the beginning of 2014, when 10-year Treasuries yielded 3%, may be in much better position to de-risk their portfolios should the 10-year Treasury yield approach 3.5%.  Such behavior could slow the rise in long-term Treasury yields and flatten the yield curve. Of course, this would depend on the impact of other factors, including inflation expectations, geopolitical risk, and Federal Reserve policy.  Investors would be wise to   recognize that even though pension funds may have had little impact on long-term Treasury yields this year, they could exert an influence should yields move higher than they were at the beginning of 2014.

 

 

ABOUT THE AUTHOR

RELATED FUND
The Fund seeks to deliver current income and the opportunity for capital appreciation by investing primarily in U.S. investment grade corporate, government, and mortgage- and asset-backed securities, with select allocations to high yield and emerging market debt securities.

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