Raising their interest

Falling interest rates might be good news for borrowers but they are very bad news indeed for pension schemes. A 1 per cent drop in interest rates means a 20 per cent rise in the value of scheme liabilities over 20 years. It is little wonder schemes are keen to hedge out interest rate risk through liability driven investment strategies, using interest rate swaps.

Pension funds want to avoid the uncertainty brought to their liabilities and funding levels by interest rates that move over time. With an interest rate swap a fund enters into a transaction with an investment bank, paying a floating rate to the bank and in return receiving a fixed rate of interest. If long term interest rates fall, pushing up the value of liabilities, the value of interest rate swaps rises, so offering protection.

“Interest rate swaps are effectively a way of buying into long term interest rates,” says Cardano client manager Phil Page. “They will offset to some extent losses incurred on the liability side so the asset versus liability position if you were fully interest rate hedged would be unchanged.” It may not be a perfect match: the risk is if liabilities are discounted with reference to gilt yields the swap may not move exactly in line with gilt yields.

Interest rate swap buyers with 20 year terms who bought the instruments in January 2011 are now sitting pretty. The value of the swaps increased 20 per cent for the year. Those who missed the boat must decide whether the current price of the swaps makes hedging a good move now. Many people believe interest rates will not fall any further.

Page says: “If you didn’t invest in interest rate swaps in early 2011, now they are yielding at 1 per cent less, so you are already arguably buying in after the big rise in price. The challenge now becomes should you hedge at these rates, and will the value of liabilities rise even further through interest rates falling further. That’s the big dilemma pension funds have.”

One of the uncertainties around swaps at the moment is the likely change in regulations both in the US and Europe to make interest rate swap trading exchange-based rather than over the counter. On the face of it this looks like a development to be welcomed, as a means of increasing transparency in the market, preventing market abuse and so reducing risk, but for pension funds there are unwelcome aspects.

Both Dodd Frank regulations in the US and the European Market Infrastructure Regulation (EMIR) in Europe are poised to introduce a similar change. Pension funds will enjoy an exemption from EMIR for three years, but after that what will happen is unclear. For pension funds implementation of the new rules would raise the cost of using swaps because of collateral demands. Two types of collateral are necessary for exchange trading - initial margins put up at the start of the trade and variation margins which are daily adjustments to reflect changing market values. Cash alone is acceptable for the latter. Pension funds would be forced to hold more cash in their portfolios, which would be a drag on performance.

Aon Hewitt principal and investment consultant Chris de Marco says: “Because most pension funds own gilts they would want to post gilts [as collateral]. Pension funds can use the repo market to create cash from gilts but that just adds another layer of transactions and if you have to repo out your gilts you have to worry about counter-party risk on the repo. It’s an added level of complexity, ultimately an added layer of cost. The cost of reducing counterparty risk is becoming more apparent in that it’s going to hurt pension funds’ returns.”

Exchange trading for interest rate swaps would also introduce a complication into the current procedures, according to Page. Because only interest rate swaps, and not inflation swaps, which are also needed in an LDI strategy, are set to be exchange traded, two different systems would have to be operated side by side, making the process less efficient.

Page says: “The exchange requires a certain amount of collateral posted upfront. If the inflation swaps are on a different mechanism you can’t net off collateral you might receive on interest rate swaps against what you might pay on inflation swaps.”

A further consideration is that while reducing some risks, inevitably other risks would be introduced into the trading of swaps. One is concentration risk which would increase for pension funds, because in a clearing house most participants elect to clear swaps through one counterparty. SECOR Asset Management head of global portfolio solutions Scott Peng says this would expose pension funds to the same sort of fraud that was perpetrated in the case of MF Global where a futures entity started using client money for its own margin calls.

“A pension plan might execute swap hedges with several banks, but all the swaps would, in a clearing-house scenario, be collapsed to one counterparty, which is the exchange. Even in that scenario, you would still need to retain a swap counterparty to manage your swap and collateral movement for you. There is a concentration risk because a pension would be exposed to an MF Global event whereby the clearing counterparty misuses client money. Losses from such an event would not be covered by any exchange.”

In the Dutch market swaptions, which combine swaps and options have become popular instruments among pension funds. A swaption is an option to take on a swap when a particular trigger level is reach. The usefulness of swaptions in the Dutch context stems from the statutory requirement for Dutch pension schemes to be fully funded for pension increases to be paid.

“Dutch pension funds need positions in place to lock out losses on the pension fund if it looks as if markets are heading against them,” says JLT Pension Capital Strategies director Antony Barker. “It’s a way of protecting them on the downside from exposures which would mean they would have to scale back benefits.”

In the UK swaptions are also gaining greater acceptance. They allow trustees to tailor views so protection will kick in at a certain level of interest rates. Page says Cardano’s clients are big users of swaptions. One variation on the swaption theme enables pension funds to buy protection if interest rates fall below a certain level and also benefit if interest rates rise.

Page says: “If you can’t decide if you want to hedge or not, what you can do is a bit of hedging a bit of not hedging - a swaption is that. Pension funds are now tailoring their interest rate exposure much more, so some are saying I want protection down to this point but not beyond or I want protection from this point but not beyond there. You can tailor swaptions to trustees’ preferences and views of interest rates.”

Increasingly sponsors and their pension schemes are cooperating to coordinate their interest rate swap requirements. Barker reports a rising awareness of the opportunities for mutually beneficial arrangements. Employers and pension schemes are polar opposites in their attitude to interest rate rises: for the company borrowing becomes more expensive as interest rates rise, but pension schemes welcome the reduction in the value of their liabilities that interest rate hikes produce.

Barker cites an example of a sponsor company that had recently refinanced its property portfolio, using a hedge to protect against a 5 per cent interest rate.

“I pointed out to the finance director that the more than 5 per cent interest rate environment he was worried about for property leases was the perfect environment for his pension scheme. It turned out the duration of their leases refinancing and the duration of the pension scheme liabilities were pretty much the same. He realised they had missed a trick.”

Barker says there is increasing demand for this kind of advice from clients: “We are working with a number of companies to look at doing back to back transactions, netting off exposures against each other and trading the net position.”

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