Boosted by equity rally, pensions buy bonds to take risk off the table

“It's a very large source of demand” from the pension funds, said Jeffrey Gundlach, chief executive officer of DoubleLine Capital LP

Jan 13, 2014 @ 9:34 am

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% of its U.S. plan assets last year, from 55% in 2012, is now looking to boost that allocation to 80%.

“Companies are now getting on the bandwagon,” Ford treasurer Neil Schloss said Jan. 9.

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. In the wake of the financial crisis, 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 program.

After the 29.6% rally in the S&P 500 last year 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 the 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-markets government notes fell an average of 0.31% 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% this month, the highest since July 2011 and more than double the record low of 1.38% set in July 2012.

The selloff pushed up yields on the longest-maturing investment-grade company bonds, which pensions buy to fund future liabilities, by 0.82 percentage points last year to 5.33%. 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, said Jeffrey Gundlach, chief executive officer of DoubleLine Capital, which manages $49 billion. “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. The improvement was the biggest since Milliman began releasing the data 13 years ago.

The plans are now 95% funded, the highest since 2008. Funding fell as low as 77% 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, said Zorast Wadia, an analyst at Milliman. “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 Dec. 9.

The disparity was the greatest since 2008 when comparing third-quarter data on an annual basis.

About 70% 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 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% this year from about 30%, Treasurer Dan Susik said Jan. 9.

“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 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%.

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 bank dubbed the “Great Rotation,” now anticipates investment-grade corporate bonds will return 1.6% this year, double its projection in January.

The advance would help restore last year's 1.5% 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, said Rick Rieder, the co-head for Americas fixed income at BlackRock Inc., which manages $3.86 trillion. “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.

The 1.6% 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% increase in U.S. living costs that economists estimate in a Bloomberg survey. In 2012, investment-grade bonds surged 10%.

“It's going to be difficult to eke out a positive total return in the investment-grade market in 2014,” Mr. Pinto said. “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.”

(Bloomberg News)


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