Pension Funds in Historic Surplus Eye $1 Trillion of Bond-Buying

Some of America's biggest bond buyers are preparing to invest up to $1 trillion regardless of whether the economy experiences a soft or hard landing. While Wall Street debates the merits of each scenario, these investors are focused on taking advantage of opportunities that may arise.

One of the key components of the trillion-dollar pension fund complex is now awash in cash after struggling under deficits for two decades. This rare surplus at corporate defined-benefit plans, thanks to surging interest rates, means they can reallocate to bonds that are less volatile than stocks - "derisking" in industry parlance.

Strategists at Wall Street banks say the impact of the current bond market will be far-reaching. They are calling it "the year of the bond" and say that the influx of cash into fixed income is just the beginning.

According to Mike Schumacher, head of macro strategy at Wells Fargo, pensions are in good shape and can now move into bonds and try to match assets with liabilities. This explains the recent rally in the bond market over the last few weeks.

An interesting quirk of pension accounting is that a year like last year, with its twin routs in stocks and bonds, can actually be beneficial to some benefit plans. This is because their future costs are a function of interest rates, and when rates climb, their liabilities shrink and their “funded status” improves.

The average funding ratio for the 100 largest US corporate pension plans is now 110%, the highest level in more than two decades, according to the Milliman 100 Pension Funding index. This is good news for fund managers who have been struggling with low interest rates and have had to take more risks in the equity market.

The surplus at the largest 100 US corporate pension funds is the highest it has been in two decades. This is good news for retirees and employees who are counting on these funds for their retirement income.

The Milliman 100 Pension Funding Index is a widely used measure of the health of corporate pension plans in the United States. The index is calculated using the 100 largest pension plans in the country, and is designed to give a snapshot of how well funded these plans are.

Now, Wall Street banks have an opportunity to unwind the imbalance between bonds and stocks. They agree that the extra cash will be used to buy more bonds and sell stocks.

So far this year, flows into fixed-income funds are outpacing those of equity funds, the most lopsided relationship since July.

The extent to which pension funds' derisking has contributed to the recent rally in bonds is unclear. Some have suggested that traders may be hedging against a potential growth downturn that would impact stocks more severely.

It is clear that pension funds prefer long-maturity fixed-income assets that most closely match their long-dated liabilities. This preference makes sense given the nature of pension fund liabilities, which are typically long-term in nature. By investing in assets with similar characteristics, pension funds can better manage their overall risk profile.

Pension funds have traditionally kept some exposure to stocks in order to boost returns, but that is changing.

Once a corporate plan reaches full funding, the goal is often to reduce risk by selling stocks and adding fixed income assets that match their liabilities. With the largest 100 US corporate defined benefit funds holding a cash pile of $133 billion after average yields on corporate debt more than doubled last year, they have a clear path ahead.

Now is a great time for investors to switch to bonds, as yields are unlikely to go above their peak level once the Federal Reserve hits its terminal rate of around 5% in the middle of the year.

Bruno Braizinha, a strategist at Bank of America, said that even if growth surprises on the upside and yields rise, causing bonds to underperform, the incentive is still there.

"Given the current market conditions, Braizinha believes that now is a good time to de-risk."

JPMorgan's strategist Marko Kolanovic has estimated that derisking will lead pension managers to buy as much as $1 trillion in bonds. However, Bank of America's Braizinha says that a $500 billion buying spree is closer to the mark.

Fixed-income ETFs are seeing flows that are outpacing their equity peers. This is likely due to the fact that fixed-income securities are seen as being more stable and less risky than stocks. Investors are looking for ways to protect their portfolios from the volatility of the stock market, and fixed-income ETFs offer a way to do that.

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Zorast Wadia, principal and consulting actuary at Milliman and co-author of the pension funding index, said that the shift from equities to fixed income is certainly a pattern. "If you were even considering the merits of this in the past, now it's a slam dunk. You certainly want to do it now."

Achieving an asset-liability match has long been a goal for corporate defined benefit pension plans. In recent years, these plans have cut their allocations to equities and increased their allocations to fixed-income investments. According to the latest data from Milliman, equity allocations have fallen to around 29% while fixed-income allocations have risen to around 51%.

Pensions funds become overfunded when their assets exceed the value of their liabilities. For corporate plans, the interest rates on high-quality bonds determine the plan's "discount rate" - an indication of what they expect as their risk-free return.

The Federal Reserve's aggressive interest rate hikes have caused the rate to surge to 5.22% as of December 31, up from 2.8% a year earlier, according to a Milliman gauge.

Even though markets had their worst year since the financial crisis, corporate plans still did well because aggregate liabilities fell by $493 billion. This offset investment losses of $321 billion.

Public pension funds are more sensitive to swings in market prices than corporate defined plans. Their funding ratios have fallen along with falling markets.

For corporate pension plans, liabilities are based on a corporate bond yield curve, making the performance of equities and bonds less relevant to the funding status.

If pension fund managers were to increase their allocation by just 3% to 4%, it would translate into a bond-buying spree worth $1 trillion, according to JPMorgan calculations. Even a 6% increase isn’t out of the question, according to the firm’s strategists.

Kolanovic wrote that this represents a unique and urgent opportunity for these funds to lock in the favorable funding status by selling equities and buying bonds. He described it as a likely inflection point for equities to go lower and bonds higher.