Pension plans everywhere are in serious trouble. Pension plans in Wisconsin are about to get in still deeper trouble using leverage.

Inquiring minds note the State of Wisconsin Investment Board Clears Plan to Borrow to Juice Returns. Other states are considering doing the same. Please consider Pensions Look to Leverage Up.

Public pension funds needing to boost their returns but frustrated with hedge funds and private-equity investments are turning to one of the oldest investment strategies—using borrowed money to boost performance.

The strategy calls for leveraging pension funds' safest asset—government or other high-grade bonds—while reducing exposure to stocks.

The State of Wisconsin Investment Board, which manages $78 billion, became among the first to adopt the strategy when it approved the plan Tuesday. The fund will borrow an amount equivalent to 4% of assets this year, and as much as 20% of its assets over the next three years. The pension fund was advised by four money managers, including Connecticut hedge-fund firms AQR Capital and Bridgewater Associates.

Wilshire Consulting, which advises pension funds on investments, says leverage helps the funds meet their long-term return targets without relying too heavily on volatile stocks, or tying up their money for long stretches in private investments. Low interest rates make it impossible to meet those targets with simple bond investments. Wilshire managing director Steven Foresti says he has been in discussions with about a half-dozen funds that are interested in the leverage strategy.

Some advocates of the leveraged approach acknowledge these drawbacks, but say the strategy makes sense anyway. Most big public pensions have expected annual rates of return between 7.5% and 8%. Wisconsin, for example, assumes 7.8%.

Many analysts consider those return rates unrealistic. Yet pension funds are loath to change them because that would require local governments to get more money from taxpayers to compensate for lower projected returns. Even at an 8% return, the average public fund will have about 55% more in liabilities than in assets 15 years from now, due to recent losses and challenges in raising contribution rates, according to PricewaterhouseCoopers.

"Fixed income is a good hedge in a crisis scenario," says Rick Dahl, chief investment officer for the Missouri State Employees' Retirement System, who said he is considering using this strategy. "If I can ramp up my fixed income to the point where it gets equity-like returns that makes a lot of sense."

8% returns are indeed unrealistic. Using leverage to achieve those returns is suicidal. If someone wanted to use leverage on fixed income or equities (on the long side) the time to do that was in March of 2009. Let's take a look at a few charts.

Moody's Baa Corporate Bond Yields

click on any chart for sharper image

As yields decline prices rise.
Let's investigate prices in a wide variety of bond funds.

JNK - Lehman High Yield ETF

CYE - Blackrock Corporate High Yield ETF

iBoxx Investment Grade Corporate Bonds

The iShares iBoxx $ Investment Grade Corporate Bond Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the corporate bond market as defined by the iBoxx $ Liquid Investment Grade Index.

CFT - Barclays Credit Bond Fund

TFI - Lehman Municipal Bond Fund

CXA - Lehman California Municipal Bond Fund

BND - Vanguard Total Bond Market

In addition to the above names, I found a number of corporate bond ETFs that have been around less than a year such as VCLT - Vanguard Long-Term Corporate Bond ETF and SCPB Barclays Short Tern Corporate Bond Fund.

Mad Rush Is On

Wisconsin wants to plow into bonds now, after those rallies, with leverage?!

One thing I know for sure is that something everyone is clamoring to get into, is in or near the bubble phase.

With that in mind, please consider Corporate Bond ETFs Benefit As Sales Break Records.

As investors become more willing to take on risk, corporate bond exchange traded funds (ETFs) are in turn becoming more appealing. So much so that corporate bond buying this year has set a record.

Worldwide, investors have purchased more than $2.7 trillion of new corporate bonds this year, reports Kate Haywood for The Wall Street Journal. Contrast that with $1.7 trillion in 2008, which is when the financial crisis all but brought the flow of cash to a standstill.

Junk bond issuers have used about 75% of proceeds from sales to refinance existing debt, the highest proportion since record-keeping began in 1996. Corporate bond sales have been a boon to many companies, giving them a lifeline as they wait for banks to resume normal lending.

“Junk,” or high-yield, refers to a bond rated “BB” or lower because of a high default risk. The main reason junk bonds have had a good year is simply that investors have some risk appetite to spare again, explains Matt Krantz for USA Today.

Where's The Value?

Anyone looking at those charts should be asking "Where's the value?" Instead pension plans are asking "How do I get in with leverage?"

There is no value here and that is precisely why pensions plans have to leverage up to get the unrealistic returns they expect.

Corporate bonds, municipal bonds, credit bonds, high yield bonds are all fully valued and then some.

Bubbles form when the Fed floods the world with liquidity. We have seen bubbles in technology, in housing, in commercial real estate, in credit, in equities, and now arguably bonds.

No Lesson Ever Learned

That state pension plans are leveraging up is a huge warning sign in and of itself. That they are leveraging up in the latest "hot thing" makes it all the more likely a corporate bond disaster is just around the corner.

Thus, it's time to be taking profits in corporate bonds and equities, not leveraging into them. If corporate bonds collapse, I can all but guarantee equities go down hard right along with them.

Mish

GlobalEconomicAnalysis.blogspot.com

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