Pensions Are Still Hungry for Long Bonds Even After Tax Deadline
(Bloomberg) -- This month’s deadline for companies to tap more-lucrative deductions from U.S. pension contributions using 2017 tax rates has passed. Yet most strategists expect pension demand for long-term debt to persist, especially with yields near the highest this year.
That’s the message from strategists at firms including Goldman Sachs Group Inc., JPMorgan Chase & Co. and TD Securities. While the passing of the Sept. 15 deadline has likely helped fuel this week’s runup in Treasury yields, Wall Street analysts still see plenty of reasons for pensions to keep adding Treasuries.
That’s good news for investors wagering that curve flattening will reassert itself and that long-term swap spreads will widen. Surging equities prices give pension funds an incentive to lock in gains on shares, reduce risk and rebalance portfolios with debt purchases. On top of that, there should also be a continued bias for companies to improve their pension-funding ratios, including by buying more debt, according to JPMorgan.
“It’s psychological: There is a fear regarding Sept. 15 and that pensions aren’t buying now,” said Priya Misra, head of global rates strategy at TD. “It has already fed into the move higher in yields and curve steepening this week. There is no way to prove to investors that pension buying won’t go away, but there are many structural reasons that have nothing to do with Sept. 15 for it to continue.”
Outperformance by longer-dated Treasuries has seen the yield premium of U.S. 10-year notes over 2-year securities shrink by about half this year, although it’s steepened from the lowest level since 2007, set last month. The 5- to 30-year curve has collapsed as well.
“While we see some evidence private defined benefit plans have been buying corporate debt and Treasuries, it is unclear how much buying was directly related to sponsors taking advantage of a larger tax deduction,” Goldman Sachs analysts Avisha Thakkar and Praveen Korapaty wrote in a note. Even so, corporate pensions will likely rotate more heavily into fixed income as funding ratios improve and the Federal Reserve raises rates, they wrote.
The analysts also say state and local defined-benefit plans will probably keep adding Treasuries, and they estimate that over the next five years, public and private pensions will purchase a combined $400 billion in longer-dated fixed-income securities.
To them, that suggests the long end should continue to flatten.
One way of looking at pensions’ demand for duration, or exposure to interest rates, is through the market for long-term Strips. These are Treasury bonds that have been split by dealers into principal- and interest-only securities, mostly to cater to liability-driven investors like pensions. The amount of securities divided up like this surged to a record this year, though some traders saw its drop in August -- the first since November -- as an inflection point.
For TD’s Misra, the August dip signals a slowdown in pension demand for duration, rather than the end. She expects pension demand combining with other forces to limit any increase in 10-year yields to 3.3 percent by the end of 2019, from around 3.07 percent now.
Of course, some analysts are on alert for a potential pullback by Treasury buyers.
“Our hypothesis is that these contributions were front-loaded, and hence corporate demand for the long end should be lower through the balance of the year,” according to Aleksandar Kocic and his colleagues at Deutsche Bank AG. “The peak of the net stripping activity coincided with the peak in financing transactions intended all or in part to fund discretionary contributions.”
For veteran bond manager Dan Fuss at Loomis Sayles & Co., though, pensions have a bias to buy debt when share prices gain. The S&P 500 rose to a record Thursday.
“Every time you get another 100 points up on the S&P 500, Loomis Sayles -- and everyone else that does this -- gets a call from its defined benefit clients saying, ‘Buy some more long bonds as we just sold S&P 500 futures.”’
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