Massively underfunded public pensions are driving an epic credit boom in the corporate bond market that will likely accelerate in the coming years.
Lawrence McQuillan of the Independent Institute explained on Financial Sense Newshour this week how public pensions are being operated under rules and assumptions that would be considered criminal under Federal law if operated similarly in the private sector.
We spoke with him about his very important book, California Dreaming: Lessons on How to Resolve America's Public Pension Crisis, where he said that in order to meet their funding requirements the Big Three pension funds in California (CalPERS, CalSTRS, and UCRP) assume that "they will outperform the average portfolio return...by 21 percent every year for decades." (see here for interview)
Given their massively growing liabilities, which collectively dwarf the size of the Fed's own balance sheet, and high return requirements, our other guest this week, Brian Reynolds, Chief Market Strategist at New Albion Partners, said pension funds across the nation are pouring money into the corporate bond market leading to a "daisy chain of financial engineering."
"Pension funds," he said, "have to make 7.5%," so they are putting their money "in these levered credit funds that mimic Long-Term Capital Management in the 1990s." Those funds, in turn, "buy enormous amounts of corporate bonds from companies which puts cash onto company balance sheets...and they use it to jack their stock price up, either through buybacks or mergers and acquisitions."
"It's just a daisy chain of financial engineering and it's probably going to intensify in coming years," Brian said.
When we asked him why he thought this, New Albion's Chief Market Strategist cited two important factors: what came out of the Detroit bankruptcy and the eventual move toward Fed rate hikes.
With regards to the latter, he explained that private equity firms and hedge funds actually begin to buy corporate bonds more aggressively to paper over the losses from rising yields/lower bond prices. So, although most investors think a move towards higher rates will cause panic, Brian said, ironically, that's when you see things really start to accelerate (see Brian Reynolds: How Public Pensions, Not The Fed, Are Driving Epic Bull Market).