Tuesday, September 27, 2011

Rebalancing and the Recent Equity Pop

There are lots of reasons why equity markets have sprung back to life (and bonds have "normalized" away from lows) the past few days. The most front and center reasons include a potential European debt deal and the fact that markets were simply oversold (I agree on both fronts), but here is another... institutional rebalancing.

The Example of Corporate Pension Plans

Over the past quarter bonds have ripped, while equities have RIP'd.

This has a profound effect on many an investor, none more so than corporate defined benefit plans. As some may not know, liabilities (i.e. the benefits they must pay out to employees) are discounted using a yield made up of high-quality, long duration corporate bonds. As a result, when long bonds perform well, this is actually a negative (all else equal) event for corporate plans as their liabilities increase at roughly an equal rate. A decent proxy for this is the BarCap Long Government / Credit index (below in red). Over the long-term, corporate sponsors hope to outperform this liability by investing in a mix of assets, including (or should I say predominantly) equities (below in blue).

The chart below shows just how trying this quarter has been for the approximately $2.5 trillion in size defined benefit plans (assets off... a lot, liabilities up... a lot).

This has been an UGLY quarter for pension plans. A back of the envelope calculation puts the loss in funded status terms (i.e. how much assets they have for every dollar of liability) for a plan with a roughly 60% equity / 40% long bond asset allocation at ~15% (i.e. if they were 90% funded, they are now ~75% funded).

But what does this have to do with rebalancing and the recent bounce in equities and sell-off in rates?

A corporate plan with that same 60% equity / 40% fixed income mix would have to reallocate ~6% of their fixed income allocation to equities just to get back to that 60% / 40% mix to start the fourth quarter. 6% x $2.5 trillion (the rough size of the corporate defined benefit market) = $150 billion (note that this is down from the $200 billion just a few days back).

I'd note that all corporate plans do not have the same asset allocation and some may have flexibility to hold back rebalancing, but this is offset by other institutional investor rebalancing outside of corporate plans that is bound to / has happen(ed).

As a result, I personally wouldn't be surprised to see support at these levels for equities and less support for long bonds through the end of the week (though if we were to weight Europe vs. rebalancing in importance, Europe dominates). After that, we better get some better news (or at least less bad news).

10/1 Update: Well that post proved itself wrong!

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