End of pension fund tax break looms over Treasury market

Bond buying by corporate pension funds may have kept a lid on long-term interest rates

Joe Rennison in New York

US Treasury traders are bracing for the end of a tax break that they say has encouraged companies to funnel billions of dollars into their pension funds and helped keep a lid on long-term interest rates.

Companies have raced to top up their pensions ahead of the expiry of the tax break on September 15, and their pension funds have in turn been significant buyers of long-dated Treasuries.

Demand for long-term Treasuries has kept yields low, even as short-term rates have risen, leading to a flat yield curve and intense debate over what that signals for the economy. The terms of that debate could change depending on what happens to yields if pension fund bond buying subsides next month.

Under tax reforms introduced at the end of last year, the US cut the corporate tax rate from 35 per cent to 21 per cent, but companies have been allowed to deduct pension contributions at the old, higher rate for most of this year. The grace period was designed to encourage companies to deal with pension fund deficits.

“We have seen a lot of accelerated pension fund contribution activity this year. New money has flowed in from contributions and that needs to be invested,” said Matt McDaniel, who leads pension fund consultancy Mercer’s US financial strategy group.

Among companies taking advantage, General Electric has promised to contribute $6bn to its pension over the course of 2018. FedEx made contributions of $2.5bn to its pension plan for its fiscal year 2018, which ran to May 31, up from $2bn for the previous year and $660m for 2016, according to regulatory filings.

“One of the most powerful forces in the market place is this pension buying that is taking place,” said Tom di Galoma, a managing director at Seaport Global Securities.

Pension fund deficits, while still large, have improved in part due to rising bond yields and stock market strength. That has reduced the incentive to buy risky assets in the hope of closing the gap. Instead, many funds prefer to buy long-dated Treasuries whose returns more closely match their liabilities.

The looming tax credit deadline has added a sense of urgency to the activity. Wells Fargo analysts estimate a further $40bn to $60bn of Treasury buying from pensions funds in the coming months.

“If you put more cash into pensions now, then you get this significant tax benefit that goes away in two months,” said Boris Rjavinski, rates strategist at Well Fargo Securities. “The long end of the Treasury curve is definitely feeling this effect of Treasury buying.”

The longest maturity Treasury bond lasting 30 years has seen its yield rise by less than shorter-dated yields this year, flattening the yield curve and raising fears of a slowdown in the economy. Short-dated yields have risen above longer-dated yields before every US recession of the past 50 years.

Once September passes and pension funds have less incentive to buy bonds, some traders and analysts anticipate a rise in yields heading into the back end of the year, steepening the yield curve.

“Every day for months now there has been steady buying of 30-year Treasuries,” said a trader at one large bank. “That goes away after September.”

Others disagree. Pension funds could remain big buyers after the deadline, investing cash allocated to them before September and continuing a rotation out of equities and into bonds, said Mercer’s Mr McDaniel.

“There is a sound argument that long bond rates are unlikely to rise very quickly because there is so much pent up demand from pension funds looking to de-risk,” he added.

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