The recent market environment has proved difficult for Europe’s second tier pension systems – following a bull run in bonds and a painful bear market in equities, funded pension systems have felt the strain over the last few years. The impact of this has varied by market and degree of equity allocation – the UK being hardest hit followed by the Netherlands and other countries – few have been immune. The recovery in equities and weakening bond markets have improved things from a year ago, although funding levels are still a way off their peak.
In response, individual country regulators have been grasping the pensions nettle and increasing the focus on mark to market and pension scheme solvency. Private provision has also been affected by closer scrutiny from investors, rating agencies and accounting treatment. IAS19 has long valued assets and liabilities at market value, but historically has allowed results to be smoothed via a ‘corridor’. This flexibility may disappear in the near future with an associated impact on volatility.
Widening the range of products
Traditionally, pension schemes have turned to the bond markets for assets which match the characteristics of liability cash flows. However, given the capacity constraints discussed above, investors are increasingly turning to the swaps market to implement risk management solutions.
From a pension scheme perspective swaps can be thought of as a substitute for bonds – the key differences being that the market is far bigger and hence more liquid (transactions are made at lower bid/offer spreads than in the comparable bond markets). Swaps also provide a more flexible way to meet liabilities or to manage duration – the swap cash flows can be structured in such a way as to perfectly match an investor’s needs. This is particularly useful in the inflation-linked market as we discuss later in the article.
Based on figures from the International Swaps and derivatives Association, ISDA, open interest in this market is now running at around £ 50trn (E75trn), far bigger than the global equity and bond markets combined.
There are several reasons for the growth in popularity of swaps over the last decade. Firstly swaps have emerged as the risk management market of choice for corporates, banks, central banks, hedge funds and increasingly insurance companies (a recent survey by ISDA showed that over 90% of listed companies were participants in the swaps market). Secondly, there have been a number of developments in the swap market recently, including collateralisation and the use of break clauses, which have served to control counterparty risk exposures – in some cases to close to nil, thus increasing investor comfort about using the asset class.
Using swaps for risk management
One response to proposed changes in Holland is to increase the duration of asset portfolios to tie in more closely with the liability cash flows. A typical bond portfolio might have duration of around five to eight years. Liabilities on the other hand could have a duration of up to 20 years or more, depending on the maturity of the scheme. It would be natural to turn to the swap market to help manage the duration mismatch. Additionally, demand has been increasing for more precise matching of inflation-linked liabilities – with either domestic or Euro-zone HICP-linked inflation swaps being a natural hedging asset (we return to this later).
The following charts show the impact on a typical pension scheme portfolio of using interest rate swaps to extend duration. Prior to introducing swaps the scheme in question is mismatched with assets of duration 8 and liabilities of duration 17. The scheme is hence exposed to fluctuations in solvency or funding levels as interest rates move (as shown in the first chart). The swap overlay minimises this mismatch (the net effect is shown in Chart 1).
Swaps can also be used to manage the second order interest rate risks that a pension fund faces, such as exposure to convexity risk, yield curve rotations and so on. Pension funds with minimum interest rate guarantees can also use interest rate derivatives, for example, swaptions and CMS floors to hedge the risks that they face.

Turning to the inflation market in more detail
Chart 2 shows the cash flows paid under an inflation swap structure.
Using an inflation swap in this way allows the pension scheme to separate the liability management from the asset management. On the liability side, swap payments to the scheme can be tailored to meet the liability cash flows as they fall due. Assets can now be invested separately, and the returns used to meet the pension scheme’s commitments under the swap.
The underlying assets can be invested in a range of asset classes and currencies. If the fund manager is assessed against a total return benchmark for example, then the swap can be structured so that the fund manager makes a Euribor related payment in order to receive long dated inflation-linked cash flows. This approach is similar to the concept of ‘portable alpha’ and introduces a number of advantages to the investor. These include the ability to choose the asset manager on the basis of their ability in a certain asset class or sector, which can now be chosen independently of the nature and currency of the liabilities of the scheme.

Structure of the European inflation swap market
The European inflation swaps market has grown significantly over the past two years. Swaps are actively traded in French CPI and Euro HICP (ex tobacco and all items) out to 30 years. Liquidity in these markets has improved dramatically over the past 12 months as increased knowledge levels and regulatory changes have brought new entrants to the market.
As with other off-balance-sheet derivatives, the flexibility offered by inflation swaps removes many constraints of the cash bond market. Inflation swaps trade on common inter-bank credit, have flexible dates and (in theory) have limitless supply. Inflation swaps are frequently traded against benchmark bonds but also in isolation where there is no bond of similar maturity. The derivatives market has been of great importance to the development of the cash bond market, a co-dependency exists where the swaps market is influential in pricing new issues, which then become a benchmark for swaps.
Transparency of the swaps market is improving as the market expands. Pricing sources and information flow are more widely available than 12 months ago, and it is anticipated that transparency will continue to improve over the coming months, giving investors confidence and raising knowledge levels such that they feel confident in entering the market.
Despite the huge growth in the Euro Inflation swaps market over the past two years, and the knock-on effect this activity has had in both the UK and in the US, inflation hedging is an area of risk management yet to be fully explored by many institutions across the globe. Expectations are for very large growth going forward, uncertainty over the equity markets and regulatory changes continue to create demand for an ever increasing range of inflation-linked assets, particularly among pension funds and life companies. The inflation swaps market has been instrumental in satisfying this demand and combining this with supply of inflation from corporates, project finance, real estate has led to an active two way market.
The first quarter of 2004 has seen the inflation swaps market push longer in maturity than previously seen as institutional investors are looking for longer dated liability matching transactions. The swaps market in tandem with the government bond market is moving in line with demand in order to satisfy the investor base.
The supply side of inflation is in theory limitless, however, sourcing inflation is not necessarily the most straightforward of tasks. Swap banks are fully aware of scale of current and future potential demand for inflation-linked products and realise that cannibalising bond markets for long term hedging is not a viable strategy. Banks have therefore spent a great of time identifying sources of inflation (excluding bond issuance) in Europe. Drawing comparisons from the more mature UK market where the ‘traditional’ sources of inflation have been the PFI initiative that has used the UK inflation swaps market for around 8 years, corporates with utilities and retailers being very active and real estate transactions where inflation is embedded into long-term leases. Whilst these sources are not exhaustive they cover the majority of transactions executed in the market. The most success in sourcing UK inflation has been from banks who have strong lending relationships in the above markets. Do these same markets represent a percentage of the supply of inflation in Europe?
The PFI market in Europe is behind the UK and where inflation linkages exist derivatives transactions have not been as common. Knowledge of inflation hedging is not yet very high in Europe, although the awareness that inflation risk can be mitigated is improving and it is anticipated that as in the UK, European PFI market shall represent a source of supply in the years to come.
Corporate market
Accounting regulations have impacted the corporate market across Europe as companies are dealing with IAS39 and the resultant implications on any inflation swaps. The corporate market does offer potential future supply of inflation though as solutions are structured to mitigate inflation risk in ways which also protect the accounting position.
The real estate market in Europe also looks very promising for the future whether inflation already exists in property leases or whether it is embedded for leverage purposes. Inflation swaps, both domestic and pan European have already been transacted in Europe and look to be a very valuable source of supply going forward.
Overall, the Euro Inflation market is a very exciting place to be as new entrants become involved in the newest heavyweight asset class. Product knowledge and awareness is increasing rapidly as market liquidity and transparency improve. The market has the potential to source inflation in a variety of size and maturities in order that it may satisfy large scale demand for institutional investors. The indications are that the Euro Inflation swaps market will be an actively traded, two-way market for many years to come.
In summary, pension schemes across Europe have felt the strain of falling equity markets over recent years, and coupled with pressure from regulators and ratings agencies, are turning more and more to risk management and hedging of guaranteed benefits. This has led to an increase in sophistication and attention being focussed on a greater range of products. In particular investors are turning to the swaps market to match their inflation rate and inflation exposure, and increasingly implementing innovative structures to achieve their objectives.
Greg Mackay is global inflation product manager and Huw Williams is head of pension fund strategy
at RBS Financial Markets in London