- Pension funds have been loading up on billions in corporate debt and Treasurys, as their corporate sponsors race to take advantage of a tax rule that changes in mid-September.
- Strategists expect that this pension buying has been depressing rates, or bond yields, and after the September deadline, yields could rise again.
- But there is a longer term trend among pension funds, aimed at securing less risky portfolios, and that could mean less stock investments and more bonds— a trend that could help keep long end rates down.
Pension funds can make a big splash when they all jump into financial markets at the same time.
That's pretty much been the experience in the bond markets this year, a phenomena that has helped keep rates low and provided a steady stream of buyers for Treasurys and corporate bonds, according to strategists.
But now that it's getting into September, many pension funds, after diving in big time, may be ready to get out of the pool temporarily — or at least slow fixed income investments as summer moves into fall. That's because when the tax law changed last year, many companies were given until mid-September to deduct their pension contributions at last year's tax rate instead of the new 21 percent rate.
The buying was especially strong in the spring and summer and has clearly been a factor weighing on yields. Bond prices move opposite yields, so pension fund buying in theory would have helped keep yields lower in the Treasury market and corporate bond market than where they have been. The 10-year yield, for instance, reached its high of the year at 3.12 percent on May 18 and was at 2.84 percent Tuesday.
"They're not going going to jump out, but they are going to climb out," said Michael Schumacher, director rates strategy at Wells Fargo. Private pensions hold about $3 trillion in assets. Schumacher said the pre-tax deadline buying was so strong, it likely had a short-term impact of holding long-term rates lower. Those yields could now move higher later in September, as fund buying slows.
In the same time frame, Turkey's currency crisis has been weighing on yields but other factors that would have sent them higher have not had much impact.
"It's a powerful argument," said Schumacher. "If you think about the changes since May, we had definite increases in Treasury supply, and it's been more skewed toward the long end, and yet yields are down...Overseas buyers have been absent, and still yields are down."
But strategists say even after this surge in tax-related buying ends, there is another big driver for pension funds that will keep them buyers in the market, though not at the same hefty pace. There is critical longer-term desire to reduce risk — and that means funds will remain big buyers of bonds, a trend that could keep rates from rising more dramatically.
"There is a tax advantage for most plans to make a contribution prior to Sept. 15 of this year...saving 14 cents on the dollar," said Matt McDaniel, a partner with consulting firm Mercer, who leads the U.S. financial strategy group. "Unsurprisingly, a lot of corporations are looking at that and saying: 'Gee our pension plan is underfunded. Why wouldn't we accelerate that cash and fund it on a cheaper basis.' This in turn generates dollars into the pension system that has to go to work."
The trend to reduce risk should keep pensions big buyers of fixed income in the future and make them less dependent on equities, as many corporate-sponsored plans pay out benefits to retirees but no longer gain contributions from workers.
McDaniel said pension funds have been looking to reduce risk, as assets have risen with the stock market's gains, after diving during the financial crisis. "They're making these decisions at the same time they have a desire to reduce risk. 'Buying long Treasurys and long corporate bonds that move in tandem with my pension liabilities are going to reduce my overall financial risk,'" he said.
Schumacher estimates the 10-year Treasury yield could move up as much as 20 basis points when the funds step back from buying next month.
"I think in the near term, we have a very tangible date, which means they'll probably back away to some degree. I think that weakens the bid [for bonds] for awhile, and maybe they come back if you see equities do well and interest rates go up," said Schumacher. "They move slowly, but they're big."
He said Wells Fargo rates strategist Boris Rjavinski estimates funds would buy $40 to $60 billion in Treasurys by year end but that they would mostly complete their purchases in August and September.
"I think that it's kept rates lower than where they would have been. All else being equal, as they go away, rates should go higher," said George Goncalves, head of fixed income strategy North America at Nomura. Goncalves said the pending slowdown in pension fund buying could have also gone into the calculus of short positions in the Treasury market, now at a record high. That is investors who are betting that interest rates will rise.
Even though tax-related buying will end, BlackRock's Global Chief Investment Officer of Fixed Income Rick Rieder said he expects pension fund buying to continue at a solid pace, with funds helping to keep yields lower.
"I'm holding my view that we're going to 3.25 percent 10-years but I don't think we're going very far beyond that. This pension demand is extraordinary and it's not going away," Rieder said.
Many funds are legacy funds that are frozen by corporations or no longer held by the corporations that started them and have moved on to insurance industry ownership. Strategists expect many more to follow.
McDaniel said corporate pensions plans sponsored by companies in the S&P 1500 have improved their average funding status to 91 percent, compared to 84 percent at the beginning of the year. That number was 76 percent in the middle of 2016.
"Plan sponsors are rightly looking at this positive run up and they're saying, 'I've seen this movie before,'" said McDaniel. "They're trying to learn from mistakes of the past two decades and say, 'How can I lock in these gains and make sure I'm not exposed to these trends.'"
He said the way plans are de-risking is by holding less equities, and strategists expect them to continue paring back stocks. "If you're putting in new cash, you're looking to put in fixed income. If you're looking to de-risk there's a lot of plans that are on dynamic de-risking strategies or glide path strategies that are a very set structure of how they want to de-risk. They might say when my funded status reaches 90 percent, I might move from 40 percent equities and 50 percent fixed income to 40/60. It varies," McDaniel said.
But while the funds are responding differently, the trend is clear for the fixed income market.
As for the Sept. 15, McDaniel expects the surge buying to continue as pension funds go down to the wire.
"We'll definitely see it going on until Sept. 15, and would not be surprising to see a slight bump on Sept. 15 or that week. A lot of this has to do with how the timing of contributions works," McDaniel said.
He said for pension contributions, companies have 8.5 months after the end of the plan year to make a contribution. "What that means for a plan sponsor that has a calendar year plan, that means Sept 15 is the deadline each year, " he said.