The behavior of markets so far this year may seem to be at odds with the notion that political uncertainty is both rising and increasingly relevant. Record-low equity volatility, rates that are moving sideways, and the narrow range in which investment-grade credit spreads have been trading are factors that would normally suggest a benign outlook. But looks can be deceiving. Too much uncertainty can also create paralysis among investors. Markets may be balanced precariously, even if they are trading as if all were well. One need look no further than the U.S. interest rate environment to see the policy knife-edge at play.
When considering how an administration’s proposals will affect markets, the question is as much about how companies and consumers will respond to the possible changes as it is about the exact policy details. Since President Trump took office, confidence indicators have moved sharply higher, into territory that would typically suggest increased spending by businesses and consumers. Yet after years of disappointingly weak business investment and rising consumer savings, most investors and economists are taking a wait-and-see approach.
This show-me-the-spending stance on the economy is clearly reflected in the rates market. Nearly all of the move higher in nominal yields in the past several months has been the product of a rebound in inflation expectations, whereas real rates remain low. If the Fed surprises us on the hawkish side this year, it will likely be because wage inflation has accelerated on the back of an improvement in real GDP, telegraphed by the confidence indicators. If the Fed then follows through on discussions to unwind the SOMA [System Open Market Account] portfolio, or the newly appointed members of the FOMC [Federal Open Market Committee] are considerably more hawkish, then rates are unlikely to stay anchored at current levels.
The counterargument to a forthcoming rise in rates is that secular stagnation—negligible or nonexistent economic growth—will continue to weigh on the United States for some time, given global debt levels, poor demographic trends, and the accelerating pace of disruptive technological innovation. The U.S. may be less exposed to secular stagnation than Japan and Europe, but the foreign exchange markets have a way of globalizing such issues. Time has already proven that the dollar will strengthen as growth accelerates and interest rates rise. In turn, a strong dollar hurts exports, creates a drag on large-cap profits, and challenges the financial stability of dollar-sensitive emerging-market countries like China. Similar to the beginning of 2016, the U.S. economy remains susceptible to dollar risks, but this time the Fed may have far less flexibility to respond because wages are rising.
The outlook for credit remains equally uncertain, mainly due to corporate tax reform. Few would dispute that the U.S. corporate tax code is in need of a competitiveness overhaul; however, the desire to produce legislation that is revenue-neutral makes the details particularly important. How Republicans plan to pay for a reduction in the corporate tax rate from 35 percent to 15 percent (Trump’s opening gambit) is at the heart of the matter. Two options have been put forth: a border-adjusted tax and the removal of interest deductibility. Both proposals are likely to be tough sells to corporate America; Washington lobbyists will no doubt be very busy this year. However, of the two options, there appear to be fewer obstacles to eliminating interest deductibility.
From a modern capital structure theory point of view, the robust growth of the U.S. corporate debt market can be directly traced to the combined effects of a 35 percent marginal tax rate and the ability to deduct interest. Academically speaking, the United States is about as far as can be from the idealized Modigliani-Miller world, where the proportion of debt versus equity capital makes no difference to a company’s valuation. Indeed, the current tax code encourages U.S. companies to issue debt to fund shareholder payouts; facilitates debt-funded M&As (including leveraged buyouts); and makes for a more fragile, debt-laden corporate America. Furthermore, multinationals are incentivized to borrow in dollars and shift profits abroad.
Moving to a corporate tax system that removes the inherent advantage of debt over equity could be very desirable from a policy perspective, but it would also introduce a high potential for disruption in the corporate debt markets. An immediate issue is how the transition to the new tax code would work. If the interest deductibility of existing debt were grandfathered, there might be a short-lived but highly destabilizing rush to issue before the effective date. Alternatively, policymakers could opt for a multi-year phased-in approach, which could lead to a higher high-yield default rate. Either way, corporate issuance could slow considerably in the future as companies reduced their proportion of debt relative to equity over time. How tax-efficient vehicles such as real estate investment trusts (REITs) and master limited partnerships (MLPs) would be treated is unknown.
For corporate bond valuations, the binary nature of tax reform is playing havoc with return forecasts that rely on assumptions about supply versus demand. The U.S. investment-grade corporate bond market expanded by 8 percent, or $650 billion, in 2016. If the growth of the market were to slow to between 1 percent and 2 percent, as could easily happen, the spread with which corporate bonds trade relative to Treasuries would likely narrow considerably, all else equal. Demand for corporate bonds would simply overwhelm supply. On the other hand, if efforts to reform the corporate tax code were unsuccessful or temporary (as were the Bush tax cuts), corporate leverage likely would remain elevated, the advanced age of the business cycle would continue to be a concern, and valuations would tend to appear more stretched over time.
A Time to De-risk Defined-Benefit Plans?
What might these broad macroeconomic themes mean for corporate defined-benefit plan de-risking and, more broadly, for liability-driven investment (LDI) strategies? This year, political risk should trigger defined-benefit plans to revisit the implementation of their LDI strategy, to either affirm or adjust their approach. In particular, changes in risk/reward incentives that result from policy changes may make future conditions very different than the situation of the past several years. Historical rearview-mirror judgments may become worthless.
Consider the following scenario: A company with a defined-benefit plan has a $100 million pension deficit today, but has the ability to issue more company debt to fully fund the pension plan. From one perspective, this would be a transaction that would not impact the overall leverage of the company—it would simply eliminate the pension debt in exchange for more company debt. From another perspective, though, it may deliver a return to shareholders of more than 30 percent if the reduction in taxes on U.S. businesses, as currently under discussion, takes effect.
Assuming that the sponsor would eventually need to make the same size contribution to the pension plan, Figure 1 (below) shows the prospective benefits to the company. Now, this may not be a fair assumption because the plan sponsor may be comfortable living with a mismatch between plan assets and liabilities. Nevertheless, in today’s market—where a return in the high single digits is hard to find—this calculus may lead to significant action across corporate plan sponsors.
In general, companies that make cash contributions to their pension plans before mid-September 2017 can deduct those contributions against their 2016 taxes. The first source of savings is the higher value of deducting the cash contribution against 2016 taxes versus taxes in 2017 and beyond. If corporate tax rates were reduced from 35 percent to 15 percent, the company would see $20 million more in tax savings if it contributed to its pension plan over the next several months, rather than after September.
The company may also benefit from an immediate pension contribution because the future of tax deductibility of interest expense is uncertain. Assuming the annual interest cost on the company’s new debt is 4 percent per annum, and that its future tax rate is 15 percent, the value of the interest deduction is $600,000 per annum. One recent thought is that interest deductibility will be phased out over five years for all debt incurred before the tax reform plan becomes law. Based on an 8% return on invested capital, this tax shield savings amounts to $2.4 million over that period on a present-value basis.
The last source of savings is based on current law—no changes required—reducing the impact of the increased variable-rate premiums from the Pension Benefit Guaranty Corp. (PBGC) that corporate pension plans are required to pay. Essentially, the PBGC charges each pension plan an annual insurance premium, with one component (the variable-rate component) based on a percentage of the plan’s funding deficit. This percentage was only 0.9 percent as recently as 2013, but it was 3 percent in 2016 and is scheduled to rise to 4.2 percent in 2019, with further indexing for years 2020 and beyond. Assuming the pension plan in our example has enough participants that the per-participant cap doesn’t apply to its variable rate premium, if the company reduces its pension funding deficit by $100 million, it will reduce its payment to the PBGC by $3 million in 2016. Figure 1 shows the annual savings over the next five years, which amount to a present value of $14.7 million.
In total, these potential savings amount to $37.1 million if the company contributes $100 million over the next few months.
If a significant number of corporate plan sponsors adopt this strategy, and if they’re focused on reducing funded-status volatility, they may cause a spike in the future demand for high-quality fixed income assets. In fact, a number of plans have already utilized this strategy in advance of tax reform, including Delta Airlines, Verizon, and FedEx, to name a few. We anticipate that once there is further clarity on the tax reform package, this demand may continue to grow.
It’s also worth noting that in the low-interest-rate environment of the past several years, the credit spread curve has been steep, which means that an investor gains a considerably higher incremental yield on a longer-maturity bond than on a shorter-maturity bond. In a rising-rate environment, investors may see this credit spread flatten. We have begun to witness this phenomenon in the banking sector. In addition, in the longer term, if interest deductibility is removed from the U.S. tax code and if future corporate bond issuance declines relative to the current pace, the lower supply of corporate bonds would likely result in lower long-term average corporate spreads. Both of these prospective changes in the market might make today’s corporate bond spreads considerably more attractive than a future state with much lower spreads.
Putting It All Together
When a company has reviewed these important considerations regarding the future supply of and demand for corporate bonds, its next step is analyzing an attractive strategy for proactively addressing the anticipated changes in the credit markets. It is very easy to replicate interest rate and equity exposures via derivatives, but nearly impossible to replicate long-duration corporate bonds via derivatives.
The optimal strategy going forward for plan sponsors may be to allocate their pension assets to corporate bonds with a mix of Treasuries. Under such a strategy, the bonds would help control the interest-rate and credit-spread risk of their liabilities, because interest rates are fixed for a longer term, while the Treasury assets could provide collateral support for an equity overlay. This strategy would allow plan sponsors the flexibility to maintain expected return targets while opportunistically taking advantage of buying the de-risking asset that is closest to the liabilities in physical credit before credit spreads potentially narrow and drive up the long-term cost.
2017 looks to be a pivotal year, as political risks may change historical supply/demand relationships in the markets. Investment opportunities will accrue to investors able to navigate these changing tides.
Jodan Ledford is head of client solutions and multi-asset for Legal & General Investment Management America (LGIMA). He joined the company in 2013 as head of U.S. solutions. In 2017, Ledford’s role expanded to include oversight over each of the distribution, client relationships, solutions strategy, product, and multi-asset portfolio management areas. Prior to joining LGIMA, he was executive director and business head of asset liability investment solutions at UBS Global Asset Management.
Jason Shoup joined LGIMA in 2015 as senior portfolio manager and fixed income strategist. Prior to joining LGIMA’s Fixed Income Portfolio Management team, he spent 10 years at Citigroup, where his most recent position was director, head of U.S. high-grade credit strategy, where he advised institutional clients and published credit research reports. Jason holds a B.S. in physics and applied mathematics and a B.A. in humanities, magna cum laude, from Seattle University and a masters of financial engineering from the University of California at Berkley.