Has the Fed Defused the Neutron Bomb?

Via Pension Pulse.

Bruce Friesen of Global Investment Solutions forwarded Randall Forsyth's article which appeared in Barron's earlier this week, Deflation: the Neutron Bomb of Balance Sheets:

Low interests rates have made these the best of times for borrowers but the worst for savers and investors.

Blue-chip corporations never had it so good with the likes of Dow Jones Industrial Average members International Business Machines (IBM) able to issue new three-year notes at 1% and Johnson & Johnson (JNJ) paying less than 3% for new 10-year debt.

But
these historically low bond yields have a darker side: According to a
new report from Fitch Ratings, ultra-low interest rates will exacerbate
the underfunding of many U.S. corporations' pension plans.

Just as with American workers who have failed to save enough for retirement and have seen their assets lose value, companies also will have no choice but set aside more of their earnings. And just as that means belt-tightening for consumers, it means corporations have less to distribute to their shareholders.

The
burden of funding traditional pension plans—known as defined-benefit
plans—is why they have waned in Corporate America. More common are
defined-contribution plans—such as the ubiquitous 401(k)s—that have
supplanted DB plans in the private sector. As has been reported widely,
DB plans remain the standard in the public sector, which are decimating budgets of many states and municipalities.

But,
according to Fitch, the low-yield, deflationary environment is adding
to the problems of underfunded corporate pension plans. Again, the
problem is two-fold: The decline in the values of investments, such as
traditional stocks and commercial real estate, has hurt the asset side.
The rush into so-called alternative investments such as hedge funds
right at their peaks didn't help. The flip side is that low interest
rates increase the present value of future liabilities.

(Time
out for those who aren't finance geeks. If you put $1 in a savings
account at 7%, in 10 years you would have $2. Trust me on that. That
means the future value of $1 in 10 years, compounded at 7%, is $2.
Conversely, the present value of that $2 invested for 10 years is $1.

But
what if interest rates are just half as high, or 3.5%, a far more
realistic yield for a 10-year, high-grade corporate bond? The present
value of that $2 in 10 years is $1.42. Trust me again on that, or get a
financial calculator or find one on the Web. In other words, where it
took only $1 for you to wind up with $2 in 10 years if you invest at 7%,
it takes an investment of $1.42 to end up with that same $2 in 10
years at 3.5%. That means you have to set aside 42% more today to meet
your savings goal a decade hence.)

Thus,
a decline in bond yields can be as devastating to a savings plan as a
drop in the stock market. According to Kenneth S. Hackel, president of
CT Capital, a financial advisory firm, 1% cut in a retirement plan's
assumed rate of return is roughly equal to a 15% decline in stock
prices.

Fitch's analysts find the mean assumed return for
corporate pension plans in 2008 and 2009 was 8%. That's with an
allocation to fixed-income assets of 34% of the total. Treasuries and
investment-grade corporate bonds yield far less than 8%, which is
closer to the very long-term return from equities, which means they
haven't locked in much of yesterday's higher yields. And, in case you
need to be reminded, over the past decade or so, the return from stocks
has been practically nil.

In line
with Hackel's rough calculation, Fitch reckons a 1% cut in the assumed
discount rate for companies' DB plan can result in a 10%-20% increase
in the present value of future liabilities. How to bridge that gap?

"The
fact is that there are no shortcuts—prudent management will likely
require contributions well in excess of the minimum required given low
yields and low equity returns," Fitch analysts write. Simply hoping for
higher equity returns or bond yields simply isn't prudent, they add.

So,
what's the answer? You know those hefty cash holdings on corporate
balance sheets on which the bulls keep harping? Fitch thinks pension
funding requirements will have dibs on corporate cash flows, and then
the stock of cash on companies' balance sheets.

That's the thing about deflation; it's like a neutron bomb for corporate, public-sector and consumer balance sheets.
Asset values and returns get decimated while liabilities remain
standing. Except that falling interest rates make those future
liabilities more onerous, requiring more belt-tightening, which only
exacerbates the deflation.

As I've repeatedly
stated, deflation is the arch nemesis of the financial sector and the
Fed will do whatever it takes to avert it. Moreover, in order to address
pension deficits, you need a rise in bond yields (lowers present
value of future liabilities) and a rise in asset prices. In other words,
you need a lot more days like Friday where stocks took off and bond
yields backed up.

The Fed's policy has been geared towards the
big banks and their big hedge fund clients. Reflate and inflate is the
official policy. By borrowing at zero and investing in higher yielding
Treasuries, banks lock in the spread, making instant profits which they
then use to trade risk assets all around the world.

Is this
policy succeeding? Yes and no. It's helping banks shore up their balance
sheets and some elite hedge funds who thrive on volatility, but doing
little to help the real economy which remains weak at this stage of the
cycle.

However, that all may be changing. Over the weekend, I
will go over some encouraging signs that receive little or no attention
in mainstream media. Below, listen to an interview with Nigel Gault,
chief U.S. economist at IHS Global Insight as he discusses his views on
the US economy and his take on Ben Bernanke's speech at the Fed's annual Jackson Hole confab.

Comments

[AUD]

"Thus, a decline in bond yields can be as devastating to a savings plan as a drop in the stock market"

Yes Leo, and balance sheets should be taking this into account.

Antal Fekete has been saying this for years. Otherwise known as capital destruction caused by lack of gold redeemability.

[NoVolumeMeltup]

Leo, do you ever think that maybe financial analysis isn't your calling?

Just asking, not hating.

[Mark Noonan]

Oh, come now - give us at least one encouraging sign, right off the cuff.

[Sudden Debt]

At least the Iranians get to build their nuclear bomb as Obama chickend out.

Good enough for ya?