Losing interest?

Sandra Haurant explores whether regulatory changes will reduce pension funds’ take-up of interest rate swaps

They first appeared on the market more than 30 years ago, but it has taken interest rate swaps until the past decade or so to really claim a strong place within pension investing. Today, though, these derivative instruments play an integral part in the strategies of many pension schemes. Used to hedge rather than for alpha, they are now a valuable tool for de-risking.

“The backdrop to the use of interest rate swaps probably started in the mid-2000s when the Pensions Act 2004 made liability profiling more explicit,” explains the UK’s National Association of Pension Funds (NAPF) investment policy adviser Helen Roberts. “As a consequence people started to look at matching liabilities more closely and there was a pick-up in derivative activity in 2005 and onwards.

“Traditionally pension funds invested in gilts, inflation-linked bonds and corporate bonds to try to meet their liabilities more closely,” says Roberts. “But in the last few years, derivatives have become more popular.”
Perhaps this rise in popularity is not so surprising, after all they seem to provide solutions to several of the problems shared by pension funds. The derivatives market now encompasses ways and means to hedge an enormous variety of investment risks, and swaps have grown faster than most types of derivatives. These days they are one of the most useful ways to hedge the risks pensions most commonly face.

Interest rate swaps essentially involve two counterparties, for example an investment bank and a pension fund, entering into a contract where they agree to exchange interest payments over a fixed time and on a notional underlying amount. One of the parties (the investment bank) pays a fixed rate, and the other (the pension fund) pays a floating rate. The interest rate swap helps to shield against interest rate fluctuations and effectively protects the fund by matching gains and losses on the swap contract with those on the fund’s liabilities.

These instruments have advantages that make them attractive to pension funds that need to tightly manage their portfolios and avoid holding cash, as global investment consulting practice Aon Hewitt’s partner in the asset liability modelling, risk and derivatives team, Yves Josseaume, explains: “The wonderful thing about interest rate swaps is that they lock in bond prices without the need to put money up front or leave equities too early.”

They are now, says Josseaume, a “major tool in pensions risk management”. He adds: “I think pension schemes need them. Those who have used them over the past few years have done tremendously well with them. Swaps have become very valuable – they have been among the best performing assets over the last 10 to 20 years. Nothing else compares.”

Some argue that the complexities of derivatives are off-putting to trustees who may not have enormous amounts of financial experience. “I would say swaps are still considered mainstream but there are people who would prefer to refrain from using them. But swaps are not the most complex derivatives, they are not as difficult to understand as swaptions or bond forwards, for example,” says AXA IM’s liability driven investment team head Erwan Boscher.

While many trustees do have a financial background and will be comfortable with a whole range of different instruments, there are plenty who do not feel at ease, and for them increasing awareness and understanding is important, says Roberts, not just when it comes to swaps but for all liability driven investing. It’s also key to understand the ways in to these instruments. “Pension funds can invest directly, but you can also access interest rate swaps through pooled vehicles,” she says. “This is the preferred route for local authority pension schemes in particular.”

But while these investments are more accessible than ever, interest rate swaps could be facing some significant changes. Global regulatory developments, in the shape of Basel III and the European Market Infrastructure Regulation (EMIR), for example, could alter the way interest rate swaps are used.

In future, swaps could go through a central clearing house, so that they would effectively be listed in a similar way to equities.

Many parties welcome the move, saying it would bring increased transparency and make trades more straightforward. “EMIR could make the trading of swaps much easier and more user-friendly as you would have an index of swaps, and it could help to mitigate counterparty risk [the risk of the other party in the contract not meeting its obligations],” says Boscher. And Josseaume agrees that regulation could bring real improvements: “Trustees are often worried about transparency and the fact that derivatives are opaque so these regulations will help that.”

However, some argue that the changes regulatory bodies will bring in are likely to have a negative effect on investment in interest rate swaps. Omgeo head of derivatives strategy Ted Leveroni says: “I think there will be some unintended impacts on the price and supply book with interest rate swaps. There is a cost involved in clearing – there are major cost implications here. The regulations and the changes in the marketplace will impact on every interest rate swap trade. They may in fact be easier to trade, but I think that cost is going to be the biggest issue. There may be margin cost impacts that they [pension funds] may not have had before.”

Execution costs, says Leveroni, could be so onerous that investors are put off the interest rate swap space entirely, leaving a void. “I don’t know of a substitute for interest rate swaps aside from selling bonds in one area and buying them in another, which incurs costs and there are limitations,” he says.

The NAPF has also voiced its concerns that margin requirements under EMIR could have serious consequences for pension funds. Those that use interest rate swaps to hedge risk could find that increased cost burdens brought about by the regulators could dissuade them from hedging, leaving them exposed to greater risks. “The proposal to introduce central clearing for all derivatives will force pension funds to post initial margin as well as variation margin,” explains Roberts. “This move could increase the cost of using derivatives. There is an exemption in place at the moment for pension schemes. Let’s see if this is extended post 2015.”

The potential cost increases are difficult to quantify, and the jury is out as to whether they will have a significant effect on the way investors approach interest rate swaps. For Boscher, the increases in cost due to the regulatory changes, as well as the introduction of the financial transactions tax, are likely to be widespread, rather than affecting just a small area of the investment market: “It is unlikely investors will review only derivatives, it is really more general than that. It may increase the cost on all sorts of trades.”

Josseaume believes the changes are unlikely to be great enough to push investors away: “The cost is still unknown,” he says. “The latest guesses from leading derivatives managers suggest that there will be some extra cost, but that it is not big enough to deter pensions from hedging.”

It remains to be seen just how great the impact of the regulatory changes will be. Alternatives to interest rate swaps are not easy to come by, so finding a different path which avoids them could present challenges.

“There are a few new assets which could be considered as interest swap alternatives,” explains Roberts. “These are liability matching surrogates and they include such assets as infrastructure, social housing and ground rent. The inflation-linking element to these assets makes them attractive to pension schemes.”

But even if cost is a burden, there is little evidence as yet that investors are moving away from this space. “So far we have not seen a decrease in use of derivatives. There has not been a massive decision to stop using them because of the forthcoming regulations,” says Boscher. “The industry has been adapting successfully to changes like these for years, and it will continue to adapt to the upcoming changes, too.”

Sandra Haurant is a freelance journalist

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