Why the Yield Curve is Flat & Why It May Steepen

Author: David R. Kotok, Post Date: August 7, 2018

We will offer readers a few references so they can become quick studies on why certain changes in the tax code are distorting the shape of the yield curve (flattening it) and why that distorting effect will change in about six weeks.

Market Commentary - Cumberland Advisors - Yield CurveThe first link is to BDO. It describes the defined-benefit pension plan funding issue that applies. https://www.bdo.com/insights/assurance/employee-benefit-plan-audits/carpe-diem!-accelerating-defined-benefit-funding-t.

Now here’s Deloitte on this subject. https://www2.deloitte.com/content/dam/Deloitte/us/Documents/Tax/us-tax-considerations-for-accelerating-deductions-for-qualified-retirement-plans.pdf.

Let’s try this in English.

If you are a corporation and have an unfunded defined-benefit pension liability, and you fund it before September 15, you can take the tax deduction at the old 35% corporate income tax rate. After September 15, that deduction rate drops to 21%. Obviously, if you know your liability and/or can estimate it, you can fund now whether you have the cash or must borrow it. By doing so, you save 14% of the payment you might otherwise have to make.

The next incentive is the fact that if you are underfunded, your Pension Benefit Guarantee Corporation (PBGC) underfunded penalty rate will be rising next year. So funding now saves you a future and rising cost while it also absolutely saves you tax dollars.

Last, another incentive is that, when you improve your funding ratio, your penalty rate assessed by PBGC goes down.

So what happens to the money once you fund it? By using Treasury strips (a zero-coupon, compounding US Treasury obligation that is financially engineered by dealers from longer-term US Treasury notes and bonds) you can lock up the funding of your long-term pension liabilities. When you do, your creditworthiness according to rating agencies goes up, and your funding ratio is more secure. Fixed-rate instruments are treated differently from variable-rate assets (stocks) when PBGC determines underfunding penalties.

Here’s a sample calculation. Suppose your unfunded liability estimate for 30 years from now is $100 million. You can neutralize it fully funded today for $40 million by purchasing a 30-year strip. You save 14% of $40 million ($5.6 million) if you do it before September 15. You also obtain other benefits like a lower PBGC rate, which you can use for your next-year earnings projections. All these favorable adjustments will appear in your third-quarter filings if you are a public company.

Put this all together and there are huge incentives for certain companies to buy US Treasury strips, and those companies have been doing so in increasing amounts.

Barclays reports that US Treasury stripping activity has accelerated. Here are numbers from the US Treasury. (We present them in first-half-of-year increments so there is no seasonality distortion.) H1 2015 stripping was $1 billion; H1 2016 was $6 billion; H1 2017 was $14 billion; and H1 2018 was $26 billion.  Note that the US Treasury auctions about $14 billion of 30-year bonds each month.  So in the first half of this 2018 year the equivalent of about 1/3 of the newly created long bonds were stripped.  For the corresponding period in the previous year that was about 1/6.

Part of this stripping increase is due to the rising allocation to fixed income as the stock market has risen. That allocation is up from about 39% directed to fixed income in 2013 to 45% in 2017. Remember that a rising allocation to fixed lowers the penalty from PBGC.

But the other part of this increase in stripping is motivated by the tax code changes. There is no way to know just how much each is responsible for, but we do know that the stock market was essentially flat in H1 except for the FANG stocks. So we can infer that a great deal of the jump in stripping was due to the effect of the special tax treatment.

There is currently no way to know what happens after September 15, when the tax break expires. But we can draw some inferences.

We know that pension funding is rising and pension plan underfunding is falling. And we certainly know there are strong incentives to act before September 15. Note that this incentive applies to the private sector and not to public-sector underfunding. Public entities do not pay federal income taxes.

Stripped Treasury securities tend to be held to maturity by many buyers. Pensions are a key example. These are called “preferred habitat” investors switching to a market segmentation approach. Here is a pretty good definition and discussion. When you consult this link on Wikipedia, scroll down to section 3.3 for the details on preferred habitat and on market segmentation, which are applicable now. These factors are altering the yield curve. https://en.wikipedia.org/wiki/Yield_curve .

Let me sum this up. There is a tax code change, and it expires on September 15. It is creating an incentive for preferred habitat buyers of US Treasury strips. Those strips are easily created out of new issuance by dealers. They can also be created from seasoned bonds, but new issuance makes it more predictable for dealers to meet demand. There will be US Treasury auctions of 30-year bonds in September and again in October, so we will be able to see if there is a month-over-month change in demand for long-term Treasury bonds.

There are always other influences on Treasuries pricing and the yield curve, so it is impossible to isolate a single cause; but we have drawn inferences, and we will have some comparative evidence after the tax-break expiration on September 15.

We expect that the curve will reflect these changes after the September Treasury bond auction, which is tentatively scheduled to occur before September 15. So while the Fed may raise the short-term rate in September, the yield curve may not flatten as much as some people think it might. In fact, the curve may surprise them and actually steepen due to the expiration of this unique tax effect.

For bond portfolios, this is exactly why we feel that barbells with changing duration in active management are far superior to passive ladders.

David R. Kotok
Chairman & Chief Investment Officer
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