Interest rate derivatives professionals are expecting pension fund managers to resume hedging reinvestment rate guarantees this year, a trend that pushed up swaption volatility two years ago. Sean Notley, head of U.S. and European interest rate derivatives trading at Morgan Stanley in London, expects proposed regulatory and accounting changes in the Netherlands to cause funds to enter the swaps market, much like the changes that caused Danish funds to hedge in 2001. Bankers also expect Swiss funds to join the fray.
Euro swap spreads in the 30-year portion of the curve could flatten to zero from current levels of between 2.5-5.5 basis points if Danish pension funds re-enter the market or if Dutch pension funds begin to hedge their guaranteed annuity exposure, traders said. A large proportion of hedging has already been completed, but if the equity markets fall for the fourth year in a row, renewed hedging could surprise market participants, said Fred Goodwin, director of financial strategies at Lehman Brothers in London.
Some Danish pension funds did continue to enter swaps last year, but it was not as dramatic as 2001, when some Danish pension funds put on a mass of trades in which they received fixed and paid floating in the long end of the swaps curve to hedge reinvestment rate guarantees, said Morgan Stanley's Notley. Because most of the funds that needed to hedge--those with exposure to mortgage-backed securities--did so in 2001, there was not a lot of exposure left to hedge, so activity was down by approximately 60% last year.
Poor Equity Returns
However, shaky equity markets could spur some funds to enter swaps to hedge exposure this year, said Mike Grayland, head of interest rate derivatives trading at TD Securities in London. This is because falling equity markets cause a decline in the value of pension funds' portfolios, thereby limiting their ability to pay out guaranteed annuities. "There's plenty of room for the markets to go haywire," Grayland added.
Another reason why pension funds were not as visible last year was swap rates rallied so they did not have to enter structured products to get the increased yield. This is because higher interest rates give a pension fund larger coupon payments on the fixed income portion of their portfolios to pay out guaranteed annuities. For example, 10-year swaps were at 4.6% in November 2001 and rose 80 basis points by May, said Jean Dumas, head of European relative-value research at Deutsche Bank in London.
Throughout last year there were rumors of Dutch pension funds entering swaps. Investors who were attempting to frontrun the pension funds ended up with painful positions throughout the year, which they either tried to unwind or reverse, according to bankers. A common trade was a conditional flattener, where an investor would purchase an option to receive fixed and pay floating on 30-year swaps and sell an option to receive fixed and pay floating on 10-year swaps. In 2001, hedging activity drove the difference between the 30-year and 10-year swap to 20 basis points from 60bps. But last year the spread widened to 45bps, according to traders.
