Dutch pension funds received billions of euros as additional collateral on swap contracts last week in the wake of rapidly declining interest rates.
Liability-driven investment managers at Achmea Investment Management and NN Investment Partners, which deal with swaps used by pension funds for hedging their interest risk, said that checking whether banks and central clearing houses could fulfill their obligations required a lot of attention.
Last week, the 30-year swap rate – schemes’ main criterion for discounting liabilities – nose-dived, entitling pension funds to billions of collateral within two days.
During periods of a modest rates decline, the collateral exchanges usually involve no more than hundreds of millions.
Menno van Eijk, head of treasury at NN IP, said that his LDI managers were on highest alert.
“Collateral is exchanged on a daily basis. As soon as we know how much it is, we immediately enter into a contract with money market funds in order to invest the received cash on the same day”, he explained.
“Therefore, it is important that our custodian receives the collateral indeed.”
Pension funds invest in swaps in order to hedge the interest risk on their liabilities. If interest rates decline, swaps’ value increases. As a result, they offset rising liabilities and slow down a declining pension fund’s funding ratio.
Part of the contract with a bank or central clearing house is the exchange of collateral. If interest rates fall, the pension fund receives collateral, and vice versa.
NN IP said it only received cash on both centrally cleared swaps and swaps directly concluded with banks.
Achmea IM said it received cash from clearing parties, but accepted Dutch, German and French bonds from banks. It invested the collateral in short bonds of the highest credit rating issued by local governments, including Dutch local councils and provinces, as well as German federal states.
Erik-Jan van Dijk, head of treasury and derivatives at Achmea IM, said: “We want to ensure that the money is quickly accessible in case interest rates rise again and we have to return collateral.”
“We want to ensure that the money is quickly accessible in case interest rates rise again and we have to return collateral”
Erik-Jan van Dijk, head of treasury and derivatives at Achmea IM
As the 30-year swap rate rose slightly this week, part of the collateral has been returned to the banks. As a consequence of the large amounts of collateral received, pension funds can use part of it to rebalance their investment portfolios, for example through buying additional equity.
Following recent equity losses and rising yields on government bonds and swaps, the ratio between schemes’ matching and return portfolios has become unbalanced relative to their strategic asset mix.
Both LDI managers said current limited liquidity in the market is driving up transaction costs. Van Dijk said he kept on thoroughly monitoring whether banks could fulfill their obligations.
“Market volatility is enormous and liquidity is often very limited. We don’t want to get caught out by surprise if a bank defaults after receiving several hits.
“European rules established since the financial crisis have increased protection of banks’ counter parties, but you never know whether they will really work in practice.”