The $3.2 trillion corporate pension industry has quietly been throwing its weight around the bond market.
Managers of the huge retirement funds, by most accounts, are in the midst of a big shift into bonds. The move makes perfect sense, given that the plans are as well-funded as they’ve been in years. After all, equities remain close to record highs, so defined-benefit systems should naturally cash in and buy fixed-income assets, which more closely resemble their liabilities.
Plus, new tax legislation gives companies a further push to fund their pensions — they can lock in a higher deduction for those contributions through September. All the while, fees from the Pension Benefit Guaranty Corp. are making it expensive for corporate America to shortchange retirement plans. These are all positive developments for the health of these systems and for the retirees who may depend on the promised income.
What’s less clear, however, is whether this trend is healthy for bond markets.
There’s good reason to believe that pension demand for long bonds is an unseen driving force behind the flattest U.S. yield curve since 2007. And if that’s the case, investors and Federal Reserve officials may be getting needlessly worked up about an impending recession.
Defined-benefit pensions, as the name implies, promise to pay retirees a set amount, usually based on a formula that takes into account age, salary and length of employment. To offset these long-term liabilities, the plans would ideally buy enough bonds with long maturities to match up principal and interest payments with payouts. The process, known as immunization, is far safer than counting on outsized stock-market profits or the performance of hedge fund managers. But it also demands a higher upfront cost and has less upside. Until now, pensions have had little incentive to reduce risk.
That’s changing, and it’s showing up in the market for Treasury Strips, a favorite of pension funds looking to match cash flows. Strips — an acronym for Separate Trading of Registered Interest and Principal of Securities — climbed almost $6 billion in May to a record $284 billion. They now command the largest share of the U.S. government bond market since 2014.
The longest bonds are the most likely to be broken into their component cash flows. The demand is keeping 30-year yields relatively contained around the highs of the past few years even as shorter-term notes reach the loftiest levels in nearly a decade.
Naturally, that difference is showing up in the U.S. yield curve. Heading into 2018, the gap between two- and 10-year notes was nearly identical to the difference between five- and 30-year Treasuries. But that hasn’t been the case for months. In fact, at one point a few weeks ago, the spread from two to 10 years was almost twice that of the five- to 30-year segment.