Good news from the bond markets

By Buttonwood

THE recent rise in bond yields may have alarmed fixed income investors but has been good news for corporate pension funds. Figures from Mercer, the consultancy, show that the aggregate deficit of S&P 1500 companies in July fell $10 billion to $212 billion; on average, the schemes are now 89% funded, the best level since October 2008.

What helped in July was that equity markets rebounded from their June losses while bond yields hung on to much of their increases. Since the start of the year, the aggregate value of pension fund assets has risen $170 billion, while their liabilities have fallen $160 billion.

Corporate pension funds use bond yields to discount their liabilities bcause pensions are bond-like in nature; paying a pension is equivalent to buying an annuity for a retiree. Indeed, when a company seeks to shed its pension liability via a buyout (see the recent example of EMI), the cost is driven by the level of bond yields at the time.

So might the pension fund problem be solved by another few months of rising equity markets and higher bond yields? It is quite possible that the figures may improve for a bit longer. But it is worth remembering that the US market still looks expensive on a Shiller p/e basis and that bonds may get some support from deflationary pressures. Bond yields are also a forecast of future short rates; the Bank of England has just joined the Fed in giving forward guidance that rates will remain low for a while.

Of course, if pension funds did get back to 100% funding, the right thing for companies to do would be to lock in that funding level via liability matching or via a buyout with an insurance company. That way, companies could rid themselves of a volatile element on their balance sheet. Whether they will do so is another matter (as indeed is whether there is enough capacity to allow a lot of them to hedge).