One of the biggest stories of 2013 was the so-called "great rotation" that was supposed to take place out of treasury funds and into equity funds. And, for a few months, it actually did take place only to see itself unwind promptly, resulting in 10 Year yields now roughly where they were in May of last year despite everyone's eager wishes to punch, kick and scream the 10 Year north of 3% yield. After all, not even the most demented permabull will dare to make an optimistic case when the 10 Year is saying there is absolutely no chance of pick up in inflation and nominal economic growth (that the bond and equity markets are both rigged, and manipulated by the Fed is a different matter entirely).
However, if the great rotation out of bonds into stocks was the story of 2013, it now appears that 2014 will see another great rotation - a mirror image one, out of stocks and back into bonds, driven on one hand, of course, by the Fed which will continue to monetize the bulk of net duration issuance for the foreseeable future, but more importantly, by some $16 trillion in corporate pension assets which after (almost) recovering their post-crisis high water market are once again, will now phase out their risky holdings in favor of safe (Treasury) exposure. As Scotiabank's Guy Haselmann explains, "The rationale is quite simply that the cost/benefit equation changes as the plans’ funding status improves. In other words, the upside for a firm with a fully-funded plan is less rewarding than for an under-funded plan."
Needless to say, the Fed, which is doing everything in its power to push marginal buyers out of a bond purchasing decision and instead to chase Ponzi risk into equities, will not be happy, especially since QE is tapering, and suddenly instead of everyone frontrunning the Fed, the momentum chasers will proceed to scramble after the largest marginal players around - pension funds, which however will be engaging in precisely the opposite behavior as the Fed!
As Haselmann concludes: "Given the decline in market liquidity and so many investors chasing the same crowded riskseeking trades, these pension flows could have a material impact on market prices for the remainder of the year. Currently, most portfolios remain over-weight equities and high yield and underweight Treasuries and short duration. However, I expect portfolios to reconsider these weightings. With this in mind, and due to factors outlined in notes earlier this week, I remain bullish on long-dated Treasury securities."
More detail in Guy Haselmann's full note below.
Private Defined-Benefit Pension Plans
There are several reasons to expect substantial changes in the asset allocation policies of corporate pension plans. Those changes should result in a significant volume of assets moving from equities and other return-oriented investment classes into lower-risk liability driven (LDI) investing strategies.
A distinction should be made between public and private pensions and between defined benefit (DB) plans and defined-contribution plans (DC). This note focuses strictly on private DB plans. There are around $16 trillion in corporate pension assets in the US of which approximately 43% are DB plans. Many of these plans were materially underfunded (more liabilities than assets) after the 2008 crises. However, after years of QE and resulting asset price inflation, a large portion of these funds have returned to near fully-funded status (97% levels on average according to most estimates). Russell Investment analysis shows an improvement of almost 15% in 2013 alone.
The trend in recent years has been for plans to adopt some type of LDI approach. This trend means that plans have adopted policies that systematically reduce investment risk as funded status improves. The rationale is quite simply that the cost/benefit equation changes as the plans’ funding status improves. In other words, the upside for a firm with a fully-funded plan is less rewarding than for an under-funded plan.
- Accounting plays a crucial part in this equation. The stream of payments made by a DB plan (the liabilities) is discounted back to a present day calculation in order to generate a targeted level of assets necessary for the plan sponsor to maintain fully funded status. Thus, the pension liability has bond-like features including an inverse relationship to interest rate movements. Therefore, aligning the duration of assets with the duration of liabilities simultaneously aligns the market risk with the accounting risk of the plan.
- This is the very reason why 2008 was so devastating: stocks fell and bond yields dropped precipitously. Lesson learned. Focusing on the firm’s guaranteed liability will better enable the firm to meet both current and future liability payments.
New premium rules from the Pension Benefit Guarantee Corporation (PBGC) further incentivize plans to drift toward LDI policies.
- Some background is in order. The PBGC administers the pension plan termination insurance program covering almost all DB plans maintained by employers in the private sector. It collects two types of premiums: a flat-rate premium assessed per participant, and a variable-rate premium based on the plan’s funded status.
- The Budget Act of 2013 signed into law increases for both types of premiums this year with further increases in every year through 2017. Plans clearly have an incentive to try to both reduce the number of participants in the plan, as well as to avoid risks that could push the fund back into deeper under-funded status.
The actions of private DB plan sponsors are, therefore, only modestly driven by their role as a fiduciary who tries to maximize return per unit of risk. On the contrary, the private DB fund manager’s decisions are based more by regulatory incentives and funding status than by return predictability.
- A few notable DB plan failures (e.g. Delta) resulted in the Pension Protection Act (PPA) which became fully enforceable in 2011. The aim of the PPA was to ensure strict oversight, larger required annual contributions, and penalties for plans that carry an unfunded liability (particularly below the 70% threshold). All ERISA and rule violations are extremely expensive.
The major factor behind the improvement in funding status has been the Fed’s QE policy, hich has fueled great increases in asset prices. Now that the QE program is being unwound, it is only prudent for these pension sponsors to position assets that mirror more closely the movement of the liabilities; especially as the premium formulas discourage risk.
Given the decline in market liquidity and so many investors chasing the same crowded riskseeking trades, these pension flows could have a material impact on market prices for the remainder of the year. Currently, most portfolios remain over-weight equities and high yield and underweight Treasuries and short duration. However, I expect portfolios to reconsider these weightings. With this in mind, and due to factors outlined in notes earlier this week, I remain bullish on long-dated Treasury securities.