The tax overhaul may cause a snag for debt-hungry pension funds.
Now being refined by the House and Senate, the legislation will likely encourage companies to bring earnings that have been parked overseas back to the U.S. With all that extra cash, firms may borrow less, reducing the supply of investment-grade bonds by as much as 17% next year, according to Bank of America Corp. estimates.
Corporate pension funds, like life insurance companies, are heavy users of corporate bonds.
Corporate pension funds have been increasing their allocations to bonds in the last few years as a way of minimizing volatility. The firms continue to move out of riskier investments in favor of debt, expanding their holdings to $877.5 billion at the end of the third quarter, according to Federal Reserve data. That’s up from $774.2 billion at the end of 2012.
Corporate tax code changes could give companies “greater access to foreign cash, so maybe they don’t have to issue as many bonds,” said Mike Moran, a pension strategist at Goldman Sachs Group Inc.’s asset management arm. A decrease in bonds “could potentially present an issue” for companies that want to buy more fixed-income assets, he said.
Plans affiliated with S&P 500 companies held about 44% in debt last year and 35% in equities, according to Goldman Sachs. Pension funds are pushing into debt for several reasons. Some are working to better match assets with liabilities, a move that tends to favor safer, fixed-income investments over equities, especially corporate bonds. And companies are expected to transfer about $19 billion of pensions to insurers this year, which often have debt-dominated books.
“It almost feels like you can’t open the newspaper or look online without seeing a headline around somebody” looking to decrease risk, said Matt Herrmann, who leads the retirement risk management group at Willis Towers Watson Plc. “It’s been a very active market.”
But the tax overhaul may create a road block. Companies sold about $1.35 trillion of investment-grade bonds in 2016 and $1.42 trillion so far this year, according to data compiled by Bloomberg. If the proposed tax changes are made into law, supply could be down 17% to $1.18 trillion next year, according to Hans Mikkelsen, head of U.S. high grade strategy at Bank of America. Morgan Stanley analysts expect issuance to decline 3%.
More investors bidding on a smaller pile of debt is likely to push up prices, leaving lower yields for pension plans that are in dire need of higher returns. Spreads on corporate bonds have fallen to the lowest in about a decade, according to Bloomberg Barclays index data.
The new tax code may make it easier for companies to repatriate money, but that doesn’t mean they’ll bring all of their overseas funds back to the U.S. And firms known for their large cash piles, including Apple Inc. and Microsoft Corp., are borrowing anyway.
Other policy changes could give pensions a boost. More lax anti-trust enforcement might fuel more mergers and acquisitions, according to Morgan Stanley analysts led by Adam Richmond. Those transactions often require bond issuance.
“Deal activity will pick up on the back of clarity about tax reform, as well as an overall lighter regulatory environment,” Richmond said in a Nov. 27 report.
Pensions could also benefit from the changes in tax policy if newly cash-rich companies put some of their extra money into corporate plans, Moran said. But that would fuel a cycle, further increasing the appetite for debt among investors competing for longer-term fixed-income assets.
That growing need for debt is creating “a real challenge, in particular for the pension industry,” said Rich Sega, chief investment officer at Conning. It’s getting harder to find enough supply to sustain the broader population of people who typically trade riskier assets for bonds as they age, he said
—Read China’s Move to Limit Risk Misses the Problem With Bonds on ThinkAdvisor.