US - A "vicious cycle" in the US pension system must be dealt with to prevent a "dangerous" misallocation of capital which could threaten financial markets, Baring Asset Management has said.
Poor returns from equity markets in the late 1990s to early 2000s, coupled with falling bond yields, led to legislative action to reduce risk after pension plans were pushed into deficit explained Toby Nangle, author of a new paper on the US system and director of fixed income at Baring.
This happened at the same time as the introduction of accounting changes that increased the risks for private plans of mismatching assets and liabilities, forcing public plan sponsors to account for massive liabilities that were previously undisclosed, he warned.
Nangle described the cycle as a “risk-less asset-run paradox”.
“Contained inflation and higher levels of Fed credibility have led to lower long-term bond yields. Falling bond yields increase the present value of future pension liabilities, which in turn increases political support for tighter regulation. More oversight increases the demand for long-dated assets, pushing down yields still further,” he explained.
Nangle has outlined three policy changes which could increase the supply of longer-dated bonds, in turn heading off what he sees as a potential crisis.
In the first instance, the US treasury should hold regular auctions to swap shorter-dated debt instruments into longer-dated debt instruments.
The bulk of new debt issuance should be shifted into long-dated conventional and index-linked securities, and municipalities should be encouraged to fully fund their long-dated liabilities by issuing long-dated debt securities, providing an additional US$1trn of liquidity to this part of the yield curve, he added.
“Without reform, the US market is likely to follow the path taken by the long-dated UK gilt market – that is to say, almost permanent inversion and much lower long-dated real yields. With the yield curve so distorted, it becomes almost useless as a meaningful economic indicator and, even worse, can lead to the severe misallocation of capita,” said Nangle.
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