In it for the long game

  • 25 May 2006
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Rising stockmarkets and bond yields in the first few months of this year have eased the solvency pressures on pension funds. That in turn gives them less of an urgent incentive to buy long dated sovereign, supranational and agency paper. But the recent correction in share prices was a timely reminder of the rationale for asset-liability matching — the trend that has boosted demand for long-duration bonds. Neil Day reports.

In mid-May Robert Parkes, UK equities strategist at HSBC in London, compared the performance of UK corporate pension funds to David Blaine's 177 hours submerged in a giant fish bowl in New York's Lincoln Square.

"UK corporate pension funds have also been underwater, but for a much longer period," he said, "approaching five years as far as the aggregate deficit is concerned. But are they about to perform their own Houdini act by wiping out the deficit and moving back into surplus at a time when many commentators are still focusing on the downside risks to the corporate sector from pension funding?"

His answer suggested that the fate of UK corporate pension funds would be healthier than Blaine's, whose choice of 'Drowned Alive' as the title of his latest stunt proved closer to the truth than he might have expected.

"Our analysis suggests that the answer to this question could easily be yes," said Parkes. "UK corporate pension funds have performed their own Houdini act. They have seen the deficit almost disappear in a matter of months."

HSBC estimated that the figure had fallen to just £11bn on a net basis. "That's an improvement of £49bn on the end-2005 estimate," added Parkes, "and leaves the deficit equivalent to just 0.5% of current market capitalisation."

This may have been galling for pension fund trustees who had followed the promptings of their advisers and switched out of equities into bonds. This trend has been a strong one in the UK, particularly since, as Parkes points out, companies' pension fund deficits and actions to address them have hit the headlines so regularly.

Across the Channel in continental Europe, there may also be many pension fund trustees who have made the switch only to face the frustration of seeing stockmarkets rise, and even, this year, a bear market for euro zone bonds.

The pressures ease

All of this has given rise to an environment where the apparent rush into long dated bonds that occurred at the beginning of 2005 has slowed.

"The whole regulatory story has been pushed a little bit to the background at the moment," says one fund manager in Amsterdam. "Last year the big story was, for example, the demand for long dated bonds for Dutch pension funds.

"Over the first few months of this year this story became somewhat subdued. That was given the good performance of the stockmarket up until the middle of May."

The rise in bond yields affected the situation in two ways. "The poor performance of the bond market made long dated fixed income less attractive," says the fund manager, "but generally speaking it improved coverage ratios for many pension funds because their liabilities are discounted against long rates, and of course, long swap rates went up quite a lot in the first few months of the year."

This has meant that pension funds seeking to match their assets and liabilities better have been able to take a less hurried approach. "The equity market rally was certainly making people less focused on solvency pressures in the euro zone and therefore more likely to sit on their hands," says Jon Cunliffe, head of interest rate alpha at ABN Amro Asset Management in London, "and some much better solvency numbers have been published in Holland, for example."

Others agree. "The funding ratios for Dutch pension funds are now much healthier," says one portfolio manager in London. "They have a target set by the Dutch regulator of around 130% of assets to liabilities, and all the evidence suggests that they have been around that level. That was because equities went up so much over a 12 month horizon and also because long dated bond yields had risen so much.

"Trustees have therefore been taking the view that, certainly in Europe, yields are going to be even higher into year end, and that gives them less impetus to switch into long dated bonds. The end of the year is the key date for them, as that is when the Dutch pension regulations come in, but until then they don't have a problem."

The tortoise and the hare

But in mid-May, just after Parkes at HSBC had made his pension deficit forecast, the stockmarkets ran out of breath.

His analysis did catch the beginning of the fall in share prices — he noted that the fall up to that point would have added £5bn to the deficit — but he was not able to take into account the slump in the FTSE 100 index over the week of May 15-19. The index slipped back to 7.8% below the five year peak it reached in April, wiping out all its gains since the beginning of the year.

As this report was going to press the markets had not decided whether this correction would be short-lived, or was an important turning point.

Irrespective of this, the fall in equities was a timely reminder that it is not just coverage ratios that pension funds have to bear in mind, but the way their assets move relative to their liabilities when market dynamics change.

Trustees largely invested in long dated bonds might not have seen their coverage ratios improve as much in the year to May as those heavily invested in equities, but they were probably able to sleep better when share prices tumbled.

Indeed, some market participants believe that now is the time to switch into long dated bonds.

Pimco, for example, launched in early May a Euro Long Average Duration Fund, to offer institutional investors a vehicle focused on just such assets. It has begun with Eu204m of paper under management.

Managing the fund is Emanuele Ravano, co-head of European investment strategy at Pimco in London. He says it was established in response to interest from clients across Europe, with the Netherlands at the fore.

The fund will enable investors to take a measured approached to investing in the long end, according to Ravano.

"People want to lengthen their duration in line with their liabilities and a lot of our clients who have been invested in more traditional aggregate bond funds are extending their duration," he says. "But they want to do it in a gradual way, and as commingled funds allow you to do so bit by bit, this new fund gives them the chance to do it at their own pace."

Time for a rethink

Ravano puts forward three reasons why the time might be right for a switch into long bonds, despite their underperformance in the first months of the year.

The first is that very underperformance. "When things look their worst, that is usually not a bad time to consider investing, given that bonds are generally mean-reverting," says Ravano.

He points out that the Lehman euro aggregate index has had a negative return over the last 12 months, which has only happened on a rolling basis six times in the past 10 years. "If you look at what happened in the subsequent 12 months on each occasion, the returns were quite positive," says Ravano.

The second reason is that the current structure of interest rates in euros implies, in Ravano's opinion, unreasonably high yields in the future. "If you look at what rate is implied for May 2016, the one year projected rate is 4.72%, and if you project it even further, say, 20 years out, it would be 4.83%," he says. "I would argue that close to 5% is way too high for yields in the future.

"Europe's trend growth is 1.8% and taking inflation of, say, 2%, you get fair value for yields of around 3.8%. So if you can lock in something substantially higher than that, it is certainly not a bad entry level."

Thirdly, Ravano expects to see renewed demand from pension funds in the Netherlands. "The Dutch have historically used 4% as a discount rate," he says, "and when 30 year yields are above 4% they see that as a bonus, because if you discount at a higher level clearly your liabilities are lower.

"They will therefore see yields above 4% as an opportunity to extend duration as they are still about 10 years short duration versus their liabilities, with their liabilities at around 16 years and their assets at six years."

The value of convexity

Beyond 30 years, 50 year yields have also risen sharply. When France auctioned its 2055 OAT in January, for example, it yielded 3.59%. By the next auction in early April this had risen to 4.14%, and by mid-May it was around 4.30%.

However, since December the 30-50 year part of the curve has inverted. Whereas the 50 year OAT was launched at 3bp over the 30 year in February 2005, it now trades at about 3bp through.

"The 50 year bond's convexity is very valuable for pension funds," says one portfolio manager in London, "because they have liabilities that are over 30 years and therefore have a higher convexity than anything that was previously available. But the duration of the 50 year becomes longer as yields fall and so it is therefore pretty critical for hedging liabilities.

"That convexity is worth several basis points and explains why this bond is being priced up. In our view it should trade 7bp-8bp through. It will change depending on market conditions, but I wouldn't expect it to trade at a positive spread for a good while."

One investor says it could become even more valuable. "If volatility picks up then, all other things being equal, the 50 year would tend to richen and we expect that to happen," he says.

"That shows you the defensive properties of the very long end in a situation where curves are a little bit more volatile than they have been.

"Curve volatility has tended to be a little on the low side and certainly more volatility in yield curves is a good thing for the fixed income investor, because it provides them with an extra platform to create alpha."

However, some investors play down the inversion. "Compared to the UK, 3bp is not really a great deal," says one portfolio manager in London. "Maybe at the margin it is reflective of the lower pressure there has been on pension funds to increase duration." 

  • 25 May 2006

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 24 Oct 2016
1 JPMorgan 317,793.98 1355 8.72%
2 Citi 301,114.13 1092 8.26%
3 Barclays 259,580.63 846 7.12%
4 Bank of America Merrill Lynch 258,842.43 934 7.10%
5 HSBC 224,273.23 905 6.15%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 JPMorgan 32,854.00 58 6.73%
2 BNP Paribas 31,678.29 142 6.49%
3 UniCredit 31,604.22 138 6.47%
4 HSBC 25,798.87 114 5.29%
5 ING 21,769.65 121 4.46%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 JPMorgan 14,633.71 80 10.23%
2 Goldman Sachs 11,731.14 63 8.20%
3 Morgan Stanley 9,435.23 48 6.60%
4 Bank of America Merrill Lynch 9,229.95 42 6.45%
5 UBS 8,781.68 42 6.14%