Long-term bond yields are a conundrum for US pension funds. They are the culprit for many of the funds’ troubles – having increased the burden of their liabilities and decreased the cash earned on fixed income assets – and they pose a big puzzle: should DB (defined benefit) plans buy long-term bonds as an investment strategy to match their liabilities? Or should their sponsors issue long-term bonds and use the raised capital to fund the plans?
General Motors (GM) boldly took the latter course in 2003, issuing $13.5bn (e10.8bn) bonds and putting the money into its pension funds, where it is actively managed, with expected returns higher than the relevant markets. It is a gamble because GM has to pay an interest rate of 7.5% on its new debt or $1bn a year in interest. On the other hand, it says that credit analysts were already counting its pension shortfall (at the time it was around $20bn) as part of its debt load, and without the 2003 deal it would have had to contribute $3bn annually to its pension funds, while now it won’t have to put in any cash for years.
It is not clear whether the gamble will pay off in the long term. In the meantime, major investment bank Merrill Lynch is urging US companies to follow GM’s example. In his latest report, ML pension strategist Gordon Latter proposes to “issue debt to fund plan deficits and capitalise on the pension-debt-arbitrage”. He explains why “this strategy is attractive at this time”. First, “it capitalises on relatively cheap money and the increased demand for long-dated bonds”.
Second, he says: “The benefits of tax-deductible pension plan contributions and coupon payments, PBCG premium savings and the additional expected return on plan assets outweigh the cost of issuance. This creates a pension-debt-arbitrage and generates cash flow savings.” He adds: “If rates increase (thereby eradicating past asset-liability mismatch sins), the potential for significant cash flow savings from adopting this strategy is even more pronounced.”
Jay Kloepfer, director of capital market research at Callan Associates agrees that “in theory it could be a good idea to issue long-term bonds and use the money to fund a DB plan”. However, he adds that a company has to look at its total debt load and its ability to raise more capital, and the shareholders may prefer to get new debt for new businesses. “The bottom line,” he says, “is that the idea would be appealing to companies that do not need it because they are already in good financial shape, as it often happens with offers from banks.”
Maybe that is why not many companies are following in GM’s footsteps. “So far, I believe GM is the only American company that has adopted this strategy,” remarks Scott Sprinzen, managing director of Corporate Ratings at Standard & Poor’s. “Most companies are reluctant to get more debts for pension purposes. Besides, they hope their investment portfolios will perform well enough to cover pension liabilities. Actually a minority of companies today face true pension problems: in 2003-2004 some of the pressure was relieved, thanks to stock performances.”
Carl Hess, global director for asset allocation at Watson Wyatt Investment Consulting agrees that “ a very small number of US companies are having real trouble with their prnsion funds”. He adds: “Despite interest rates being so low, several pension funds have moved to investing in long-term bonds, because they have understood that matching assets with liabilities is the key strategy. It’s more important than betting with peers or waiting for higher interest rates.
“It took one of the worst bear markets to convince PFs about this strategy, which we strongly recommend to our clients. If higher interest rates really come, there will be a flood of PF investments in long-term bonds, which currently represent only 5-10% of their assets.”
Compared with this huge potential demand and the $500bn already invested in bonds by all US pension funds, “the announced revival of 30-year Treasury bonds for only $20-30bn will be almost a non-event, because it’s too small”, says Hess.
Also, according to Kloepfer, the new 30-year T-bonds won’t affect the pension industry: “There will be no impact unless pension funds want it. The bonds may help those plans that are moving to an investment strategy more closely tied to what happens to liabilities. Today such a strategy is very expensive, because interest rates are so low they don’t reward the long-term risks. If the Congress changes regulation and pushes pension funds to match liabilities, there will be more demand and the new 30-year T-bonds could help satisfy it.”
However, Kloepfer stresses that today “most US pension funds pursue total return investment strategies, and rightly so. We at Callan think that matching liabilities is only one of the available strategies and it’s not the answer for everybody. It’s ok if you really believe that asset volatility concerns you a lot, but it’s going to cost you more, because you give up the potential of better results.”