A developing relationship
The degree of success of investment banks in the worlds of pension funds and insurance companies is difficult to ascertain. In part this is because investment bankers are happy to use the kind of spin that would make a politician blush. In part it is because trading is so sensitive that earnings are not readily disclosed.
The average investment mandate may last three years and be quantified by the assets under management or performance return on those assets. The business of investment banks does not show up as readily. The price a bank will give to a client in the derivatives market will only be fractionally different to its competitor, and apart from the trade, there is little other evidence of success.
If any player were to boast about its performance openly, chances are the client would receive rival offers within minutes of the news becoming public. This habit has become more pronounced in 2005 as spreads on nominal interest rate swaps have narrowed, possibly halved.
“Spreads have contracted dramatically in the last six to 12 months as asset managers ask for daily pricing,” says Gareth Derbyshire, managing director in Merrill Lynch’s Insurance and Pensions Solutions Group. “The interest rate swap business is largely commoditised for small-sized short-dated transactions,” says Richard Boardman, head of pensions strategy at UBS.
This would be bad for all the banks’ profits except that volumes are on the rise. More pension funds are accepting that they have to shape their assets to better match their liabilities.
“We already see an explosion of activity in hedging, a multiple of what we saw in previous years, and it is expected this will only increase over the next twelve months,” says Theo Kocken, chief executive of Cardano Risk Management in Rotterdam.
This growth will come in spite of the fact that for those outside the world of trading derivatives, the workings of fixed interest and inflation-linked swaps are not easy to understand.
Many pension funds will be unused to the idea of posting collateral rather than owning securities outright. There is also ongoing evaluation of a swaps programme in tandem with changes in liabilities. The latter can be affected by a number of matters such as redundancy programmes or increased mortality rates. Interest rate and inflation rate swaps do not hedge out these risks so pension funds must familiarise themselves with the protection these derivatives can provide.
The risks they help hedge out – the sensitivity of the fund to changes in interest rates and inflation - can be enormous, however. The banks are only too happy to point out that these are often the biggest challenges a fund faces.
There are anecdotal stories of UK pension funds that have stuck with equities and seen those portfolios rise in value by 50% over the last three years, only to find their liabilities have grown at a faster rate as real yields fall.
“Duration and inflation risks can be the greatest risks in the fund,” affirms Derbyshire. At the end of September the yield on the UK 30-year index-linked bond was about 1.27% and about 1.1% on the 50-year paper. Some investors might be dissuaded by such stingy returns, reckoning it would be better to carry the risk and continue with an asset allocation mismatched to liabilities. Derbyshire says that this is a common initial reaction but believes that many funds are now breaching their pain thresholds and to carry on with such a huge tactical bet is an unfavourable trade-off. “There are two types of risk: rewarded and unrewarded. If you believe in active management or the equity risk premium, these are risks for which you would expect to be rewarded.”
But interest rate and inflation risks are unrewarded risk – in other words, it is not worth taking. Pension funds have to distinguish between these two types of risk.”
Investment banks have been recruiting actuaries and fixed income portfolio managers to their ranks to promote this message. These people bring knowledge to the banks of pension schemes but also the individuals who run them and their consultants. The hours are longer but the pay is far better. Headhunters in the City of London estimate total remuneration at more than one million pounds for any senior individual with experience of managing pension fund liabilities to transfer to a major bank.
The need for these people is evident to anyone who has considered the life of pension liabilities, which are second only to nuclear fuel rods in longevity, but alas cannot conveniently to shipped to foreign waters or sunk into concrete. Even if an occupational retirement scheme today closes a defined benefit arrangement for employees, it is likely to be paying out pensions for most of the rest of the century. Actuaries model these liabilities and investment banks win business if they too can appreciate them, literally, when offering solutions.
Herein lies the first paradox for investment banking: while the price of trades is short-lived and highly competitive, the activity they support continues for decades and it is not contained within a single relationship but a complex grouping.
Rashid Zuberi, head of structured solutions for European insurers and pension funds at Deutsche Bank, notes that the banks are usually at the other end of a long chain of agents from the trustees: “In Scandinavia the large pension funds are like mutual life assurers. Insurance company finance directors across Europe also tend to be derivative-savvy. But when it comes to UK pension funds, we are dealing mostly with asset managers. The trustees will have their investment consultants and actuaries so there are a host of parties involved along the line.”
Boardman, who was previously head of risk at ISIS Asset Management and a senior consultant at Watson Wyatt, is keen to emphasise that UBS does not want to disintermediate the consultants. Indeed all the banks display respect for those agents with whom they are often likely to have dealings, especially the asset managers and consultants. “In some cases we have suggested asset managers which we think the client ought to consider,” says Dawid Konotey-Ahulu, head of the Insurance and Pensions Solution Group, Merrill Lynch.
Asset managers and actuarial consultants are important to the banks because the modelling of liabilities and the swaps to move in line with them are related. Just as actuarial consultants earn a large portion of their income from liability studies, so the investment banks dedicate a lot of time to modelling the income and inflation-linked swaps. Zuberi reckons the gestation of a swaps program may be six months. Others put the whole talking process at three years. All of which suggests that in spite of the cliché as fast-thinking, fast-acting traders, the investment banks are sensitive to others’ needs.
Undoubtedly those with a background in consultancy are by nature, but even they acknowledge that the modelling leads to trading, which is where the banks make their money. This is the distinction from actuarial consultants which still gives rise to some wariness. Head of Europe for Barclays Global Investors, Nigel Williams, has warned that in one instance an investment bank was prepared to use information acquired in a pitch to trade against the pension fund client whose business it failed to win. Europe’s most influential investment consultant in liability driven investment (LDI), Nick Horsfall of Watson Wyatt, has made it clear that banks exist to trade and that some have approached his clients with inappropriate products for their condition. Evidently such players are not respecting the other agents in the world of pension funds, or are unprepared to play the waiting game.
Such anecdotes are reminiscent of the late 1990s, when the greed of traders infected the analysis of companies up for flotation on NASDAQ. That was when technology and telecommunication stocks were the most important entities to finance in the world. Today’s environment reflects how pensions and insurance groups within investment banks have, to some extent, replaced tech stock analysts as the catalysts of trade.
During the bubble of the last decade, accountants rather than actuaries were in demand in financial centres, as accountants could pore over the balance sheets of prospective IPOs.
But changing regulation across Europe means that pension costs are both more visible and better protected. In some recent acquisition activity, the pension fund has been centre stage.
For a while the investment banks merely pointed up the threat these changes presented to the investor community, notably the downgrades by credit ratings agency, S&P’s to German industrial giant, ThyssenKrupp in February 2003, all prompted by pension obligations.
But such analysis benefited only the asset manager clients of the banks, who could make portfolio decisions based on potential costs posed by attendant pension obligations.
Some banks, however, notably Goldman Sachs and Morgan Stanley, had already seen that more money was to be made by finding ways to help these corporations with pensions rather than merely evaluating the threats for the benefit of asset managers. Every cloud has a silver lining and this duo of banks was among the first to establish European pensions and insurance groups, although alongside the likes of Credit Suisse First Boston, their early years’ profits came from transitioning assets and generating equity trading revenues. Before the arrival of the euro, they executed programmed trades for large Euro-zone investors. But few pension funds have not reduced equity exposure in the last five years.
Today it can be said that the banks’ actuarial and debt specialists have usurped the role of star analysts in generating business, for not only does a bank earn on trades associated with managing liabilities but in the world of mergers and acquisitions, understanding pension obligations is now essential.
In the UK, it is no longer possible for a solvent employer to walk away from defined benefit liabilities and pension costs have played a part in torpedoing or delaying at least three possible take-overs in the retail sector, WHSmith by Permira, Marks&Spencer by Philip Green and Somerfield.
Both prospective buyers and sellers in the corporate world are more likely to select a bank which can advise on these risks with experience. In other words, pensions groups inside investment banks are going to have a useful life beyond trading.
Before considering the role of trading, it is worth airing one more issue regarding the banks’ commitment to this market. Pension fund managers are sceptical that investment banks will be around in the same form in 20 years’ time, unlike the funds themselves. This can be a concern when it comes to counterparty risk although it does not seem to represent an even view of the deal.
Schemes, after all, do not seem as concerned with the frequency of change in their asset managers, even though these will be counterparty to the banks in any swap transaction. Zuberi nevertheless acknowledges the fears: “There are clauses in the legal agreements where the banks will endeavour to transfer the risk to other banks in the case of credit concerns or changes of control due to mergers.”
One asset manager involved in LDI pointed out that an asset manager is likely to spread any large deal among banks in order to mitigate risk. In this sense the mandates are no different to securities management where competition is fostered by sharing business out.
But while there are deep, transparent markets for quoted securities – reflected in the tightness of spreads on securities index derivatives such as S&P500 futures – it is not clear which banks hold what sources of interest-paying and inflation-paying debt.
This helps explain market participants’ reticence in divulging prices. No one is quite sure how comfortably their competitors can satisfy client demand. Evidently, business is so fierce on nominal spreads that it is a buyer’s market. But opinion is far more mixed on inflation and analysing quoted spreads only tells half the story because the banks will not reveal how much they have paid their sources on the other side; typically, utilities whose income tends to be inflation-linked, securitised property rental income for the same reason, and possibly in the UK Private Finance Initiatives, although this market is not great in size. It is worth repeating that no successful bank will hold all the risk on its own book; they are intermediaries.
UK banks such as RBS and Barclays Capital are recognised as the stronger players in inflation-linked derivatives. “The UK has a longer history of trading inflation than Europe,” notes Kocken. “But the French banks are strong in euro-denominated inflation.” Knoken sees only six to eight players in inflation-linked derivatives. The list for nominal interest rate derivatives, including swaps and swaptions, is far greater, including many Continental banks such as the local trio of ING, ABN AMRO and Rabobank in the Netherlands.
Guy Cornelius, co-head of European distribution at UBS, claims that it has a 15-20% share in the UK index-linked market, ie physical assets rather than derivatives. “If a bank cannot source nominal or real debt, it prices itself out of the business,” he claims. “It means you are going to a market-maker every time clients demand assets and that incurs extra cost.”
Goldman Sachs and Morgan Stanley may have seniority as established pensions and insurance groups, but Cornelius believes that people are willing to speak to newer voices. UBS is one of the players sending out daily prices to foster liquidity and competition.
Other banks, however, point out that there is much more it than simply market share of the index-linked cash market. “It is one factor in the holistic picture,” says Konotey-Ahulu. “You can have all the inflation in the world on your book but if you have not been talking to the sponsor, the asset manager and the consultant, then you have less chance of getting the business.”
Both Konotey-Ahulu and Cornelius claim to have executed three LDI trades in recent months. UBS claims to number one in swap transactions for European insurers, which moved far sooner than pension funds. Zuberi puts Deutsche Bank in the top three in both pension fund and insurance business. But there is no objective quantification of which houses are actually winning most.
Some banks do not pretend to be everyone’s partner. In Copenhagen, Anders Herskind, chief analyst in the institutional solutions group at Danske Bank sees a diversified product palette, local knowledge and local presence as its greatest strengths. “We aim to understand all the things which make up our clients’ business,” he says. “No doubt coupled with a longstanding relationship with the client in many cases gives us the opportunity to meet their needs.
Herskind observes a growth in Danish clients’ use of derivatives. Historically, Denmark’s Financial Services Authority removed derivatives from the toolbox following scandals such as Orange County in the 1980s. But since the end of 2003, almost all restrictions have disappeared so long as investors display understanding of the risks they are taking. “They started out using passive strategies. Since then clients’ ability and appetite to use more complex derivatives has increased,” says Herskind, “and in the last couple of years we have seen a tremendous growth in the use of complex derivatives including products to restructure interest rate, equity and credit risk exposure.”
Having sorted out risk at the total fund level, Herskind believes Danish institutions now manoeuvre their portfolios around more nimbly than before. The use of derivatives is significant and advocates of LDI, including all investment bank derivative trading desks, would be heartened by Herskind’s view. With nominal bond spreads so tight, banks appreciate any extra business and equity futures or active duration bets count in this category.
Of course, Danske Bank is not restricting itself to the Danish market. Alongside the bulge bracket banks it is eyeing Sweden, which will introduce new traffic light regulations next year – the next draft from the Finansinspektionen is expected on 6 December. With a dearth of long-dated bonds and without any peg to a larger currency, Sweden is going to provide an interesting challenge to all parties. In terms of business, however, the UK will remain Europe’s largest source, at least until Germany makes any concerted reform. As there have probably been fewer than 30 British pension funds to implement swap programmes, it is evident that the business has someway to go to catch the hype.
For pension funds still in doubt about these derivatives and their vendors, they can take heart from the views of an experienced asset manager involved in the business. “There is not that much difference between a Goldman Sachs and a Morgan Stanley on price. It is much of a muchness and the market operates a lot on trust, otherwise it would simply crumble.”
Those with experience of the contracts such as asset managers should obtain a fair price but even they would not know if an investment bank was overreaching itself. Probably most employees in the bank would not. Only a natural disaster or extreme market shock would reveal such a fault and that does not bear thinking about.