Gentlemen Prefer Bonds

U.S. stock prices are no higher today than they were in 1999, and the purchasing power of the major market indices has made no progress in fifteen years.  Meanwhile, the yield available on ten-year Treasury bonds has dropped from close to seven per cent in the mid-1990s to below two per cent.  Not surprisingly, the superior investment performance generated by default-free Treasuries has severely dented the notion that equities are the safest asset for long-term investors.

The sub-par returns generated by stock markets over the past decade has been accompanied by a marked change in the asset allocation of defined-benefit pension plans, with many corporate sponsors electing to reduce their equity exposure and increase their fund’s weighting in fixed income securities.  The latest corporation to effect such a change and capture public attention was Ford Motor Company, who announced earlier this year that it intended to lift the proportion of its pension fund assets invested in bonds to 80 per cent, up from 45 per cent previously.

The trend towards the de-risking of defined-benefit pension schemes has sparked an avalanche of commentary from so-called investment experts, who argue that the asset allocation switch is misguided and could prove to be anything but riskless should the yield on Treasury bonds increase from generational lows to more normalized levels.

Of course, similar arguments were made more than a decade ago when Boots, the British pharmacy retailer, liquidated its entire equity portfolio and moved all of its pension fund assets into high-quality fixed income securities.  Importantly, then as now, the arguments are bogus and demonstrate a complete lack of schooling in elementary financial theory.

The decision to replace equities with bonds in a defined-benefit pension scheme is not a call on the long-term returns expected from either asset class, but a strategy to reduce financial risk, by investing pension plan assets in securities with a duration that better matches the duration of liabilities.  Minimizing the volatility of the value of pension plan assets relative to pension liabilities reduces the probability that a company will have to divert capital and make costly deficit contributions, most likely at a time when the firm can least afford them.

It is important to appreciate that holding equities in a defined-benefit pension scheme increases a firm’s overall leverage, and in turn, the expected costs of financial distress.  Although a defined-benefit pension fund and its corporate sponsor are legally separate entities, the economic reality is very different, and since the company is ultimately liable to meet the pension liabilities, the balance sheets should be consolidated to give a complete view of the firm’s capital structure.

Suppose a firm has $1,000 in operating assets financed by $250 in debt and $750 in equity, which gives a debt/equity ratio of one-to-three.  The capital structure appears to be relatively conservative, but suppose the company has pension liabilities of $500 and pension assets of $500, with $350 invested in stocks and $150 in bonds.  The stocks can be thought of as ‘negative firm equity,’ and the bonds can be regarded as ‘negative pension liabilities.’

A complete picture of the firm’s capital structure, which includes the pension plan in the calculation of leverage, shows that the debt/equity ratio increases from one-to-three to 600/400 or three-to-two.  The pension plan’s asset allocation seriously increases the firm’s overall financial risk, and the observation clearly matters, since academic research confirms that such information is impounded in stock prices.

Further, should the market determine the capital structure to be appropriate, it is still not suitable because the company is forgoing the opportunity to exploit the valuable tax shield that would arise from financial leverage on its own balance sheet.  The same capital structure could be achieved and the tax shield utilized by switching the pension plan’s stock holdings into bonds, while issuing the same amount of debt at the corporate level and using the proceeds to repurchase an equivalent amount of its own shares.  This is akin to the strategy adopted by Boots in 2001, which was so widely criticized at the time.

The de-risking of defined-benefit pension plans continues with Ford Motor Company recently announcing its decision to increase its bond allocation to 80 per cent.  The strategic move has been challenged by investment professionals, who fail to appreciate that just as there are two sides to every story, there are two sides to every balance sheet.

Perhaps the last word on this controversial issue should be left to the late Fischer Black, who wrote in 1980, “My message is simple.  Almost every corporate pension fund should be entirely in fixed dollar investments.”

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