Bank of America Corp strategists say a “massive rotation” of corporate bonds from stocks may be on the horizon for US pension funds as they become fully funded.
The investment gains pushed the capitalization ratio of the 100 biggest business plans to 98.8% in May, according to Milliman. This measure of defined benefit pension plan assets relative to liabilities has increased by 82% since July 2020, according to data from the risk management company.
If interest rates continue to rise, BofA expects the ratio to exceed 100%. This would trigger a significant move towards high-quality debt by corporate pensions seeking to lock in earnings, the bank said in a credit strategy note, “The Elephant in the Room.”
“I think it’s becoming a pretty big story, and it’s becoming support for back-of-curve credit spreads in particular,” said Hans Mikkelsen, head of high-quality credit strategy at BofA, in an interview.
Over-capitalized corporate pensions will likely sell riskier assets like stocks and buy annuities from insurance companies, Mikkelsen said. Insurance companies would then mainly cover themselves with higher quality corporate bonds with longer maturities.
“These are legacy plans. It has been a headache for companies for a long time to have and underfund them,” Mikkelsen said. “Now maybe they can make this problem go away without putting new money into it. “
Private defined benefit pension plans held $ 3.5 trillion in assets at the end of 2020, nearly half of which was in stocks, according to Federal Reserve data.
BofA expects high-quality US spreads to be wider in the near term, forecasting a rate hike cycle faster than what is currently reflected in the market. If that happens, the reallocation of pensions would likely support long-term credit and flatten the spread curve, Mikkelsen added.