Most people don’t expect high-pressure sales tactics when buying long-term corporate bonds. There usually isn’t a guy in a goofy jacket waving around a handful of certificates yelling that you have to buy now while supplies last.
But current market conditions inspire a reasonable concern for many U.S. pension sponsors that, at some point in the foreseeable future, there simply won’t be enough long bonds available to meet their needs. Let me explain what’s going on and why that concern shouldn’t necessarily translate into pressure to act.
Rising interest rates bring benefits and concerns
Ever since the 2008 financial crisis, we’ve heard predictions of an “inevitable” jump in long-term interest rates, perhaps reverting to pre-2008 levels.¹ In such a scenario, long bond prices would fall, and pension liabilities would drop as well. For many pension sponsors, this would boost their plan’s funding status—an improved position that they may want to lock in by selling stocks and buying long bonds.
So what’s the downside that has sponsors concerned? There’s a finite supply of investment-grade, long-term corporate bonds, approximately $1.6 trillion in value.² Much of that supply is already held by long-term investors such as insurance companies and pension funds that aren’t likely to sell in a rising rate environment. Compare that $1.6 trillion supply with the $3 trillion in total asset value held by corporate pension plans,³ and you can see the cause for concern.
Concerns don’t need to change your plans
Buying now—selling equities or other return-seeking assets to buy long bonds—may be a prudent idea for many pension sponsors, especially those concerned about their plan’s funding status risk. Adding long bonds increases the predictability of the plan’s funding position, which generally helps stabilize the sponsoring organization’s financials and reduces risk.
However, we don’t recommend making portfolio adjustments specifically to “beat the rush” into the fixed income market if the move isn’t aligned with your pension’s investment objectives. Markets have historically tended to adapt to find an equilibrium between supply and demand.
If a rising rate environment increases demand for long corporate bonds, the market would likely respond in one or more of the following ways:
- Higher bond prices driven by downward pressure on interest rates and/or credit spreads.
- Increased supply of long corporate bonds as new issuers enter the market to take advantage of the strong demand.
- Increased availability of substitute products providing exposure to the corporate bond market.
In particular, it’s possible that strong demand for long corporate bonds could cause credit spreads on those bonds to narrow substantially relative to long Treasury bonds. In that case, long Treasury bonds could serve as a desirable substitute for corporate bond exposure by offering a similar yield with lower risk of default.
Of course, some potential for supply challenges in the face of sudden rate moves does exist, at least temporarily (since some of the market adjustments already mentioned could take some time to materialize and stabilize). During a period with limited availability of bonds, pension sponsors and bond fund managers could potentially utilize interest rate or credit derivatives to maintain their desired market exposure.
The problem may fix itself
As noted, if long-term yields rise, so will demand among pension investors for long corporate bonds. This increased demand would drive bond prices upward, suppressing the rise in yields by impacting credit spreads and/or rates.
Importantly, this same reaction in the bond market would also suppress the rise in pension funding status. This, in turn, would likely stifle the swell in demand for long corporate bonds.
Long story short: It’s not easy to see a future scenario in which long corporate bonds are both seen as historically cheap and also unavailable for purchase.
In summary, increasing a plan’s allocation to fixed income reduces funding status volatility and so is always worthy of a plan sponsor’s consideration. However, we encourage plan sponsors to exercise caution before deviating from their strategic objectives simply out of a concern for future market dynamics.
¹ While Vanguard acknowledges that a spike in long-term rates is within the realm of possible future outcomes, it is not part of our base case economic forecast, nor is it an implied expectation by the market as a whole based on the current shape of the Treasury yield curve. An in-depth discussion appears in our 2018 market outlook.
² This is the market value of Barclays Long U.S. Corporate Bond Index as of September 30, 2017. Note that approximately half of this amount is for bonds rated Baa—the lowest rating in the investment-grade space, and seen as suboptimal for liability hedging by some pension investors.
³ Source: U.S. Federal Reserve, Financial Accounts of the United States, as of September 30, 2017.
- All investing is subject to risk, including the possible loss of the money you invest.
- Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
- While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.