Between a rock and a hard place
News that a conference on longevity and the capital markets in February was so massively oversubscribed that a video link had to be set up to accommodate the overspill demonstrates just how topical this issue has become recently.
The conference came on the heels of news that both the French and UK treasury departments plan to consult the market on whether to launch 50-year bonds.
All this interest, not coincidentally, comes as yields are tumbling and prices are rising as European pension funds scramble to buy longer-dated paper to meet their liabilities.
The Bank of England (BoE), citing market intelligence, has added its weight to reports of heavy buying at the long end. It identified an explicit link between pensions and long-bonds, saying it was possible that financial market prices had “responded to the prospect of increased saving in the future”.
There is a regulatory impetus as well, of course, with the new FTK in the Netherlands and new regulations in Sweden essentially forcing mark-to-market disclosure.
Interestingly, the French reserve fund, the Fonds de Réserve pour les Retraites, has made it clear that it is keeping its powder dry in the bond market because yields are so unattractive.
Under Holland’s Financieel Toetsingskader, or Financial Assessment Framework, which comes into force in 2006, Dutch pension funds will have to calculate their liabilities at
current market rates instead of a fixed rate. There have been market rumours – denied of course – that the Dutch government might delay the new rules in the face of a powerful industry lobby.
And new Swedish regulations are being prepared that would mean that schemes may have to mark their liabilities to the market instead of the current fixed 3.5% rate.
Denmark switched to fair value accounting in 2001. Funds increased their exposure to bonds by up to 40% and decreased their allocation to equities by some 70%.
“That’s the number-one issue in Holland at the moment – duration extension,” says Ruud Hendriks, head of continental European institutional business development at
Goldman Sachs Asset Management (GSAM).
Hendriks says that while a “wider stable of instruments is becoming available” they would “not necessarily” solve all the schemes’ problems. He says: The question is: is it a 100% match? Is it mathematically done? All pension funds are looking at the moment.”
Hendriks pointed to Denmark, where pension schemes have already gone into longer-dated instruments including swaps. He said some Dutch pension funds “have taken some action already” towards moving into longer-dated bonds. “They are making moves, it doesn’t mean they’ve done it all. All pension funds are looking for alternative sources of income.”
What effects could there be from such an unavoidable shift into fixed income? Clearly, there will be a lower equity allocation, as well as perhaps a restricted appetite for other types of assets. By being in effect obliged to ramp up their fixed income holdings, how much upside elsewhere will funds miss?
It seems like history is being repeated. Not that long ago, it was more transparent accounting standards coming in at just the wrong time – as schemes became underfunded. Now, it is regulatory pressure to go into bonds – again at just the wrong time, with yields scraping the bottom of the barrel.
And the speculators, the hedge funds, know that schemes need bonds, so they are apparently in there as well. And hedge funds were supposed to be the saviours for hard-pressed schemes. Pension funds are truly caught between a rock and a hard place – they’ve got no choice but to buy these instruments.
So we are faced with the intriguing possibility that hedge fund money – some of it no doubt belonging to pension funds – may be working against pension schemes at the long end at exactly the worst time.
Merrill Lynch has said there is “almost limitless demand” for long-duration bonds, both conventional and inflation-linked.
Pieter Omtzigt is a Dutch MP who is pensions spokesman for the CDA, the Christian Democrats. He says he expects the FTK to reveal that there are quite a few schemes below a 100% coverage ratio. The rail scheme SPF would have sufficient assets, he says, the rest could be underfunded.
Part of the problem, Omtzigt argues, is a fundamental shift in the global economic outlook. “Low rates are here to stay,” he says. The decline in the cost of capital has “huge implications for the pension industry”.
He maintains that within the pension industry “no-one’s really looking at what low interest rates mean – I mean the abundance of capital”. He reckons that the way out is to look at more durable, not just “hit and run”, investments abroad.
The European Central Bank has recognised the problem. “Exceptionally low interest rates have pushed investors towards certain forms of investment and have led to a strong increase in prices in certain asset markets,” executive board member Tommaso Padoa-Schioppa said in a newspaper interview.
And the BoE notes: “The fall in equity prices between 2000 and 2003 – and the resulting shortfalls in some pension funds – may have led to a reassessment of the costs of funding retirement and a reduced willingness to take risk by mismatching assets and liabilities.” It adds: “That decline in equity prices may also have increased the attractiveness of bonds.”
Crispin Southgate, European credit strategist at Merrill Lynch, is pithy on the subject: “There are enough bonds but they’ve all been bought. Watch the Dutch,” he says, referring to Dutch pension funds which he said have E500bn of liabilities and most of their fixed income holdings in five-year paper. They need longer duration stock, Southgate argues.
But is there a way out for the schemes? A lot of the big suppliers such as Merrill Lynch, Rabobank and Goldman are touting swaps. As GSAM’s Hendriks says: “We believe swaps are often the preferable tool for duration extension, but risks can also be reduced using more conventional instruments such as long-dated bonds.”