Escalating M&A + pension fund crisis = inverted yield curve

The impact of pension fund demand on long dated bonds is generally understood, but few realise that rising takeover activity is amplifying this effect. In order to protect people’s pensions, the pension regulator is insisting that the acquiring company fully funds the takeover target’s pension fund deficit. Last week, for example, both India’s Tata Steel and Brazil’s CSN offered to fund Corus’ pension fund deficit of £138m as part of their takeover offers. CSN, for example, is BB rated and will have to borrow £4.35bn to fund the takeover, so the pension regulators’ concern is understandable.

 What does takeover activity and the pension fund crisis have to do with the yield curve? Well, companies have to raise finance from somewhere and, at the moment, the cheapest way of doing this is by borrowing from the debt market (ie issuing bonds). Typically highly leveraged companies such as Tata Steel and CSN have to issue short and medium dated bonds, as there isn’t much demand in the market for long dated corporate bonds from such risky entities. These highly levered entities issue fixed rate bonds, so as to protect themselves from rising interest rates. Takeover activity is therefore resulting in heavy issuance of fixed rate short dated bonds, and this pushes short and medium dated bond yields up.

If the acquiring company has to take on the target’s pension fund liabilities, then it has to raise additional finance by issuing more short and medium dated bonds. It then has to buy pension fund assets for the target company’s pension fund, and as mentioned previously, the best assets to match with pension fund liabilities are long dated bonds. This then pushes up the prices of long dated assets and drags down yields further.

So in this way, the leverage and the pension regulations combine any takeover of a company with a pension fund deficit (which is most companies) results in the yield curve inverting even further. Yet another reason why I believe that long dated bonds will continue to outperform short and medium dated bonds, not just in the UK, but throughout much of the world.