Will Higher or Lower Rates Hurt Pensions?

Randall W. Forsyth of Barron's reports, Pension Funds Should Take Care What They Wish for:

U.S. corporate pension funds are in the best shape they've been in since before the 2008 financial crisis as their shortfalls were cut nearly in half in 2013. Credit surely goes to the rising stock market, but last year's improvement in the funds' positions also owed much to the rise in bond yields.

Indeed, fully closing the gap between pension funds' assets and their future liabilities may depend more on higher interest rates than continued gains in the stock market.

Corporate pension plans among the Standard & Poor's 500 companies were last fully funded in 2007, before the financial near-meltdown of the following year. From 2009 to 2012, the plans' underfunding ranged between 16% and 23% -- with the worst shortfall in 2012, when S&P 500 index already had made a huge recovery from its recession lows.

These data cover the traditional, defined-benefit plans that were the norm for Corporate America a generation ago. As S&P Credit Week observes, U.S. companies have dealt with the burden of pension costs by shifting it to employees with defined-contribution plans such as 401(k) plans. The result: 46% of workers had saved $10,000 or less for retirement while an additional 20% had socked away between $10,000 and $49,900, according to a 2013 study by the Employee Benefit Research Institute. Only half of all workers receive any retirement benefits from their employers.

For those lucky enough to look forward to a monthly check in retirement, their employers have to set aside and invest funds to meet those obligations. Among the S&P 500 companies, 51 were fully funded at the end of 2013, up from just 18 in 2012.

The list of the most under-funded defined-benefit plans were dominated by old-line manufacturing companies, notes Tobias Levkovich, Citi Research's chief investment strategist. Leading that less-august list were General Motors (ticker: GM ), ExxonMobil ( XOM ), Boeing ( BA ), Ford Motor (F), DuPont ( DD ), Pfizer ( PFE ) and Caterpillar ( CAT. ) And that was after the 30% surge in the S&P 500 last year.

There was another, less obvious boost to corporate pension plans in 2013: higher bond yields. Given that the jump in yields, which took the benchmark 10-year Treasury to 3% from a low of about 1.65%, resulted in bond price declines and negative returns from investment-grade debt last year, that might seem counterintuitive.

But the higher yields lowered the present value of future pension fund liabilities. (A higher discount rate for a stream of future payments lowers that stream's discounted present value. At a higher interest rate, it's possible to set aside a smaller sum to meet a future savings goal, and vice versa.) The discount rate on pension funds' liabilities, which is based on the yield from investment-grade corporate bonds, rose in 2013 to 4.69% from 3.93% in 2012.

The impact on interest rates is apparent from the experience of the two preceding years. According to S&P, despite 2012's 13.4% equity return, pension underfunding among the S&P 500 companies actually increased over 27%, to an aggregate $451.7 billion from $354.7 billion, owing to the decline in interest rate and the resulting increase in the present value of future liabilities. And while the 29.6% gain in the S&P 500 index in 2013 helped reduce underfunding by over 50%, to $224.5 billion, the increase in the discount rate on future liabilities "assisted considerably," S&P observed.

While 2014 is only a bit more than half over, the trends are less positive than last year's. The S&P 500 is up 7.5%, setting another record Wednesday. But contrary to expectations of virtually every forecaster, bond yields have fallen markedly this year, to 2.47% on the Treasury 10-year note as of Wednesday, a hair above the 2014 low of 2.44%.

The gain in the S&P 500 and the fall in bond yields suggest a rerun of 2012's experience, when pension fund underfunding increased despite positive equity and debt market returns.

To be sure, writes Citi's Levkovich, "the stock market is crucial to the asset side of pension story." But given the likelihood of "modest single-digit gains through mid-2015, it will not close the gap entirely."

"The most significant impact on pensions will come when interest rates move higher, thus reducing the present value of future pension obligations, which will accelerate the time line of fully funded status," he concludes.

S&P agrees, but it also avers while higher interest rates would drastically improve the funding of corporate pensions, they would also be potentially damaging to parts of the economy.

Indeed, it is difficult to reconcile pension plans' hope for higher stocks and higher bond yields. Low interest rates without a doubt have increased price-earnings multiples as low yields have lured investors into equities. Low interest rates also have provided an important lift to corporate profits as well by sharply reducing interest costs, while stock buybacks have boosted earnings per share for public corporations. The bottom lines of financial companies such as banks also have benefitted from the reduction in loan-loss reserves, which have flowed directly to the bottom line of the S&P 500.

Thus, Corporate America -- or at least the portion that still offer pension plans -- would like higher interest rates to reduce their future liabilities to retirees. But the impact on the economy and the stock market likely would be negative.

Another reason to heed the admonition to be careful what you wish for.

Take the time to read my recent comment on when interest rates rise where I wrote:

A rise in interest rates will benefit pension plans (discount rate rises, lowering the net present value of liabilities) and savers but it will crush many debt-laden consumers and businesses struggling to stay afloat and will lead to a full-blown emerging markets crisis, which is very deflationary.

So should pensions be careful for what they wish for? It all depends on how dramatic the rise in interest rates will be. If interest rates spike up, it will hurt pensions on the asset front real hard but it will significantly lower the liabilities those pensions pay out.

Here we have to introduce the concept of duration. It's important to understand the duration of liabilities are a lot longer than the duration of assets. This means that when interests rates are low, a fall in rates will disproportionately impact liabilities a lot more than it impacts assets. In other words, in a low rate environment, when rates fall, liabilities go up more dramatically than the rise in the value of assets.

This is why many corporations are scrapping defined-benefit plans and replacing them with 401 (k) (RRSP) type plans which effectively places the onus entirely on individuals to make wise investment decisions to retire in dignity. If a bear market strikes them, too bad, they're left fending for themselves.

The problem nowadays is rates keep falling. My former colleague, Brian Romanchuk notes the bond bear market of 2014 has been delayed:

Strategists went into 2014 with a consensus bearish view on bonds (as was also the case in 2010-2013...). The market action so far has not been kind to that view, with yields plunging in the developed markets. It may be that I have fallen into a too mellow summertime mood, but my guess is that this is largely a squeeze of the bond bears during quiet markets (although there are obvious geopolitical concerns).

The JGB market has not been cooperating with those who have been calling for collapse and hyperinflation; rather yields have marched from stupidly expensive to insanely expensive levels. At a 0.54% yield, the 10-year JGB is at a very interesting position. As I have pointed out before (when yield levels were slightly higher...), the payoff on an outright short position which can be held for a considerable period looks attractively asymmetric (click on image above).

It's A Forward Story

What is interesting about the rally in the U.S. Treasury market is that it a story about the forwards. My crude proxy of the 5-year rate, 5-years forward has been marching steadily lower since peaking around New Year's. Meanwhile, the spot 5-year rate has been tracking sideways (click on image above). Therefore, the rally has not been about revising the timing of rate hikes, rather it is a downward revision of "steady state" interest rates. This could be explained by a number of factors:

• Quantitative Easing (why now?);
• belief in Fed jawboning future rates;
• forward rate expectations slowly adapting to lower realised rates;
• demand for duration by liability-matching investors.

Although I believe that long-term rate expectations needed to be revised lower from the 5% average that held before 2012 as a result of the demand for duration, 3¼% may be too far. In any event, there is unlikely to be clarity until market liquidity comes back in September.

What else explains this move in the yield curve? In a recent comment, I discuss how Japan's private pensions are eying more risk, snapping up corporate bonds, REITs, leveraged loans and U.S. bonds. And they're not the only ones. Other countries facing low yields are also looking at U.S. bonds because of the spread (see Hoisington's second quarter economic letter).

By far, the largest purchaser of U.S. Treasuries after the Fed is China (click on image below):

Investors wrestling with the mysterious U.S. bond rally of 2014 got a clue about where to look: China.

The Chinese government has increased its buying of U.S. Treasurys this year at the fastest pace since records began more than three decades ago, data released Wednesday show. The purchases help explain Treasurys' unexpectedly strong rally this year. The yield on the 10-year U.S. Treasury note has fallen to 2.54%, from 3% at the end of 2013. Yields fall as prices rise.

The world's most-populous nation boosted its official holdings of Treasury debt maturing in more than a year by $107.21 billion in the first five months of 2014, according to the U.S. government data. The buying has been fueled by China's efforts to lift its export-driven economy by weakening its currency, the yuan, against the dollar, market analysts said, a strategy that encompasses hefty purchases of U.S. assets.

China officially holds roughly $1.27 trillion of U.S. debt, about 10.6% of the $12 trillion U.S. Treasury market.

The country's purchases have salutary effects on both sides of the Pacific. In addition to the weaker yuan in China, they hold down U.S. interest rates, making houses more affordable and generally easing financial conditions in the U.S. economy.

On the other hand, lower yields mean lower income for bond investors. They have spurred investors to chase assets globally for returns, fueling asset-price increases and investor fears that some market valuations are stretched.

Also, investors fear any reduction in Chinese purchases, along with other macroeconomic events, could destabilize the U.S. bond market and send rates higher, slowing the housing industry, widely viewed as a key driver of economic growth. Some analysts contend that low rates also can allow capital to be misallocated, fueling the risk of future economic disruption.

In a bid to boost returns, China has sought to diversify its foreign-exchange holdings away from U.S. government bonds in recent years. But it finds itself having to keep purchasing the U.S. debt due to a lack of investment choices elsewhere. "There is no other market that is as liquid and deep as the U.S. Treasury market," an official at China's central bank said in a recent interview.

China's aggressive purchases of dollar assets also present the authorities with problems at home. That is because the purchases cause the money supply to expand and can fuel inflation within China unless the central bank soaks up the excess liquidity injected into the system.

The bond rally has left many traders on Wall Street scratching their heads. Most investors had forecast that interest rates would rise this year as the U.S. economy picked up steam and the Federal Reserve slowly pared its stimulus measures, in a shift that was widely expected to push rates higher.

But yields remain far below 2013 highs even as U.S. job creation has gained pace in recent months. The disclosure of China's holdings underscores the frayed nerves in the bond market as the Fed prepares to raise interest rates as early as next year, for the first time since the financial crisis. Many investors fear that reduced Fed support and unpredictable buying by foreign governments could spell bond-market tumult.

"The big picture is that China buying may be helping to keep bond yields lower than they should be ahead of the Fed moving closer to raising rates," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ. "The market could wake up and get quite a shock…if China changes course." The risk for the U.S. economy, said Mr. Rupkey, is that any slowdown in Chinese purchases could push U.S. bond and mortgage rates higher, which would put "the fragile housing recovery in jeopardy."

At the same time, many investors over the past decade have warned of the risks of reduced purchases from China precipitating a U.S. interest-rate spike—predictions that haven't been borne out.

The rise in China's Treasury holdings disclosed Wednesday marks the biggest first-five-month increase since record keeping began in 1977 and surpasses the $81 billion of Treasury debt bought by China for all of 2013, according to Ian Lyngen, senior government-bond strategist at CRT Capital Group LLC.

China has increased its U.S. Treasury holdings every year since the 2008 financial crisis except for 2011. China continued to log a trade surplus with the U.S., thanks to its aggressive efforts to boost exports over the past decade. That has led to a huge accumulation of foreign-exchange reserves, and the Treasury market is the most liquid bond market for China to invest reserves, analysts said.

China held $1.2633 trillion in notes and bonds at the end of May, compared with $1.156 trillion at the end of 2013, according to Jeffrey Young, U.S. rates strategist at Nomura Securities International in New York.

The gain reflects in part China's decision to shift its U.S. investments to longer-term securities from short-term debt known as bills. Including bills, which mature in a year or less, China held $1.2709 trillion of Treasury debt at the end of May, compared with $1.2700 trillion at the end of December 2013, according to the latest data from the Treasury Department.

Analysts have long cautioned that the Treasury report isn't a complete picture because it doesn't account for China's holdings at third-party custody institutions in other nations, such as the U.K. and Belgium.

China's foreign-exchange regulator, the State Administration of Foreign Exchange, didn't immediately respond to a faxed request for comment.

China's purchases come as U.S. issuance slows, amid higher tax receipts from an improving economy. Mr. Young at Nomura Securities International estimated that net supply of Treasury notes and bonds this year would be $650 billion to $690 billion, down from $836 billion last year and $1.565 trillion in 2010.

The Fed has been dialing back its monthly purchases as well. Mr. Young said the central bank's buying this year would account for about 38.5% of net Treasury issuance, down from 65% last year.

China hasn't been the only big buyer this year. Japan, the second-largest foreign owner of Treasury bonds, increased its note and bondholdings by $9.56 billion during the first five months of the year. Including bills, Japan's holdings of Treasury debt was $1.2201 trillion.

China's foreign-exchange reserves currently approach $4 trillion, the world's biggest in size. China doesn't disclose the composition of the reserves, but analysts say most are denominated in U.S. dollars. This year, China has taken actions to weaken its local currency to make its exports cheaper. When China sold the yuan, it bought the U.S. dollar, and analysts said China likely often used the proceeds to purchase more Treasury debt.

"China will continue to buy Treasury bonds as long as they want to keep the yuan's value lower to support exports," said Peter Morici, professor at the Robert H. Smith School of Business at the University of Maryland. "I don't think China will pull away from the Treasury bond market even if the Fed raises interest rates."

Christopher Sullivan, who oversees $2.35 billion as chief investment officer at the United Nations Federal Credit Union in New York, added that "China's investment in Treasury bonds is mostly trade driven and not opportunistic," like hedge funds or other bond traders.

U.S. bonds yield more than Germany's, which are at 1.2%, and Japan's, at 0.54%. Strategists at Goldman Sachs Group Inc., J.P. Morgan Chase& Co. and Morgan Stanley expect the 10-year Treasury yield to rise to 3% by the end of 2014. Goldman recently cut its year-end forecast from 3.25%.

Some investors caution that higher-yield forecasts may not pan out. China's buying will be "a restraint on yields,'' said Mr. Sullivan. "I think 3% is highly suspect for 2014."

No doubt about it, when it comes to interest rates and currencies, the China factor is huge. One currency trader put it this way to me: "Even if Bridgewater, Brevan Howard, Moore Capital and other big global macro shops are short the euro, the Chinese will squash them like bugs. They have huge F/X reserves and they're not marked to market."

At the end of the day, China will do what's in China's best interest. If they want the USD and euro to hover around a certain level, they can easily manipulate currency markets to boost their exports. How long will this go on? Until they create sufficient internal demand so they don't need to rely on the export driven growth model.

And there is something else driving rates lower, the ominous threat of global deflation, which is now threatening Europe. But not everyone buys the deflation story. Ted Carmichael recently revisited his inflation or deflation scenarios and concluded:

If one believes that US growth will accelerate, that current high level of geopolitical risk will diminish, and that the Rising Inflation scenario will prevail, my preference at mid-year would still be the conservative 45% Equity, 25% Bond, 30% Cash portfolio. The evolving, highly uncertain environment still argues for a cautious and flexible approach.

True but I agree with CNBC's Ron Insana who wrote an interesting comment on why inflation is about to fall -- and fall hard. Watch the clip below and read my comment on when interest rates rise. If I'm right and deflation is the ultimate end game, pensions will get clobbered on both assets and liabilities.