Pension funds across Europe are preparing to lengthen the duration of their fixed-income portfolios to comply with new accounting standards, according to attendees at the European Fixed Income Summit last week in London.
Starting in January, European-listed companies must report balance sheet liabilities at fair value rather than discounting them at a 4% fixed rate. This could dramatically increase the volatility of liability valuations in a changing interest-rate environment. To manage this volatility, pension funds are planning to increase their investments in long-dated assets and/or their use of credit-default swaps.
Implementation will take several years and vary by country. Denmark implemented the rules in 2001 and Danish pension funds have already adapted their asset management strategies. "A 1% change in interest rates implies a 5 to 6 billion change in the value of our liabilities," said Henrik Gade Jepsen, chief fund manager at ATP, a 36 billion scheme in Hilleroed. The new legislation prompted the fund to increase the average duration of its portfolio to eight years, with the duration in individual portfolios such as the European government bond portfolio raised as high as 12 years. It could not be determined before press time where the durations were prior to the shift.
Jepsen noted he is increasingly turning to the more-flexible swaps market to lengthen duration because long-dated bonds are illiquid.
Gerlof de Vrij, head of strategy and research at healthcare pension fund PGGM in The Netherlands, agreed that using swaps appears to make more sense because it reduces mismatch risk without affecting returns. He warned, however, that swaps merely transform risk from duration to money market, rather than reducing it outright.