Making supply meet demand
Media attention is focusing heavily on the demise of traditional defined benefit pension plans and the forces accelerating this demise. Some say FRS 17 is the chief culprit, as it requires companies to disclose the cost and funding status of their pension fund on their financial statements. This is arguably a counterintuitive position, as the opponents of FRS17 are in effect saying that greater transparency of corporate financial liabilities is not desirable.
The issue is not whether one should be for or against FRS17. FRS17 is the messenger that informs the investing public on the state of affairs in a pension fund. Companies in the UK have much more fundamental decisions to make on how to manage their pension fund liabilities and, more importantly, on the implications for what constitutes an optimal capital structure for their balance sheets. FRS17 has made it clear that the financial performance of the pension fund has a direct bearing on the financial health of the sponsor. FRS17 also ascribes a high level of security to the pension fund liabilities by requiring that these are discounted at AA corporate bond yields.
It is highly likely that a number of pension fiduciaries (and sponsoring companies) will look at their portfolios in the light of the recent equity market underperformance and assess whether their high equity holdings can be justified if the market environment does not substantially improve. A number of pension plans are now asking how they should think about matching their liabilities and how to acquire matching assets – ie, increase the allocation to and composition of their sterling bond portfolios.
At the simplest level, UK plans can simply increase their allocation to gilts. However, this may still expose them to a substantial duration mismatch compared to a tailor-made ‘least risk’ bond portfolio. A good example here is the misconception embedded into the minimum funding requirement test that pensioner liabilities are best matched by investing in 15-year or over conventional gilts (even though the duration of these gilts and the liabilities could be significantly different). To illustrate the risks associated with a poorly constructed bond portfolio, take the fact that matching index-linked liabilities with conventional gilts can introduce approximately 8% in active risk versus the liabilities. The lesson is simply investing in gilts does not ensure risk is adequately managed.
Motivated by FRS17 (which follows in the footsteps of its international and US equivalents, IAS19 and FAS87 respectively), trustees and plan sponsors are now focusing on how to get the best of both worlds, risk management and cost management. The solution here is building portfolios on the basis of risk-adjusted returns, including corporate bonds and gilts in combinations that reflect the specific liability and funding strength of the plan, together with the risk tolerance of the fiduciaries.
Incorporating corporate bonds and taking advantage of the yield spreads should in theory provide trustees with additional return. This return premium is a function of the credit and liquidity risk associated with these securities vis-à-vis gilts. The size of these risk premia are clearly seen in the yield spreads in figure 1. Based on FRS17 the value for pension liabilities is the ‘net present value’ of future payouts discounted at an AA-rate corporate bond yield. Using recent yield spreads this affords the plan sponsor the benefit of approximately an additional 60 basis points of yield relative to a risk-free or economic valuation.
In theory, all of the above is fine. However, there are a number of practical considerations, in terms of implementing these solutions – namely the current short supply of long duration securities, compounded by the overall shortage of corporate bonds in the UK. This shortage is particularly acute in the long-duration LPI gilts and corporates. Broadly speaking, UK pension plan assets total over £800bn (e1,305bn). The total size of the UK investment grade corporate bond market is around £250bn. A lot of this is closely held and hence not available. Clearly any significant shift into corporate bonds will create anomalies in the market.
Bond demand will be met to an extent by increasing gilt supply in the near future as the PSNCR moves into deficit – expected to be more than £24bn this year. Additional supply should also come from infrastructure-related non-government bond issuance. UK entry into EMU should solve the whole bond shortage problem at a stroke. However, setting aside the politics of EMU entry, an alternative route to meeting the increased demand is an orderly restructuring of UK corporate balance sheets, with companies issuing debt to replace bank borrowings and also to finance equity buy-ins.
This latter course has been advocated by a number of leading UK actuaries. They claim that, at an economic level, corporate UK would be better off managing its corporate risk by neutralising poorly-matched ‘bond-like’ liabilities in pension funds and acquiring offsetting risks within the operating company. The net effect is that the true level of leverage within the economy does not really increase.
In corporate finance terms there is also a case for UK companies to increase their gearing – not least because their level of gearing is significantly below that in the US. Bearing in mind that the UK and US are not directly comparable, this difference is visible from figure 2 where we can see the extent to which US companies operate at significantly higher gearing levels (expressed as corporate debt as a percentage of total shareholder capital/capital stock).
As a result, UK corporates have room to make more use of bond financing. To date, like their continental counterparts, UK companies have relied on bank borrowing – alongside equity financing. Figure 3 takes the non-financial corporate sectors in the US and UK and plots the progress of bonds as a percentage of total debt financing. While the percentage of total debts accounted for by bond financing has been steadily increasing in the UK, it remains significantly below that in the US. This represents an opportunity for UK corporates to tap into this market.
There is a certain reluctance among UK companies to increase leverage – the focus is instead on repairing their balance sheets. It is nonetheless very likely that additional demand from pension funds for UK corporate bond issuance will create the right environment for the UK bond market to continue and accelerate its growth. In addition to the scope to raise gearing levels, UK companies also benefit from cheaper financing from the bond market vis-à-vis the equity market. Simply comparing the current yield on long bonds with the earnings yield illustrates this point. Take tax into account and the case becomes even stronger. Figure 4 illustrates the extent to which the case for increasing leverage as a means to access cheaper finance is significantly stronger in the UK than the US. Time will tell whether or not UK companies will issue more bonds and leverage up their balance sheets as they effectively deleverage their pension plans and at the same time lower their overall cost of borrowing. Nonetheless, while one may question the current outlook for corporate bond supply, the forces listed above will continue to operate and will, in our view, over time drive additional supply of UK corporate bonds.
Time waits for no man and pension funds are no exception. As an alternative to constructing a significant corporate bond portfolio using the currently available supply, one can largely avoid the secondary bond market by directly approaching individual corporates to convince them to accelerate their debt raising activities. This approach can also give trustees the opportunity to influence the maturity and structure of the bond itself! It is a route increasingly being adopted by a number of the larger (and more mature) UK pension plans.
But, until UK companies change their philosophy in terms of optimal capital structures and their preference for equity financing, the current trend towards higher corporate bond allocations is destined to contribute to anomalies in the market similar to those that followed the MFR-driven shift into long gilts in 1998. That year, yields fell 29%!
Michael O’Brien is director, European product strategy, at Barclays Global Investors