Dutch pension funds should reduce the strategic weight of government bonds in their LDI portfolios by at least 10 percentage points in the new defined contribution (DC) based pension system, says BlackRock in advice sent to its clients earlier this month.
Most pension funds will reduce their interest rate hedges anyway in the new pension system, automatically reducing the amount of money invested in government bonds. However, BlackRock is advising pension funds to reduce the weight of government bonds in their LDI portfolios on top of this.
“Pension funds now invest an average of 40% of their LDI portfolios in government bonds,” says Wouter van Noorloos, an LDI strategist at BlackRock.
“As far as we are concerned, this can be reduced to between 10% and 30%. If a fund does this, in addition to lowering its interest rate hedge, it will sell on average half of all its government bonds.”
Mismatch
An important reason for BlackRock’s advice is the so-called ‘interest rate mismatch risk’ in the new pension system that exists for funds that choose the so-called solidarity arrangement.
This is the risk that the return of an LDI portfolio deviates too much from the return of the risk-free swap curve, which pension funds are supposed to assign to pensioners and other members that have exposure to an LDI portfolio.
The difference between the real return and the return of the swap curve, be it positive or negative, mainly ends up with young people via the excess return.
“We asked ourselves which investments in the LDI portfolio offer the highest reward per unit of mismatch risk. The question is which investments will yield the highest possible expected return, while at the same time deviating as little as possible from the return on the swap curve,” says Van Noorloos.
Long-duration government bonds do not come out great on this scorecard, he concludes.
Even though the effective yield on Dutch and German government bonds for longer maturities is now higher than it has been in years, and given the fact that the yield has been above that of the swap rate since 2024.
This is because the higher interest rate is offset by higher volatility in the spread between government and swap rates. The longer the duration, the higher the volatility.
Alternatives
“We think there are better alternatives than government bonds, such as mortgages. These provide a higher yield than government bonds, with a more limited mismatch risk,” notes the LDI expert.
He adds: “This also applies to short-duration corporate bonds, private debt and infrastructure.”
Answering the question of whether private debt and infrastructure loans are less likely to deviate from the swap curve, van Noorloos says: “These investments are less liquid than government bonds, but prices are more stable. This is because you shorten the interest rate sensitivity and thus the volatility. All the investments I mention have on average a duration of around five to ten years.”
He continues: “A pension fund therefore should prefer to hedge the longest-term liabilities with interest rate swaps and invest the funds that are not used for government bonds in higher-yielding investments.”
He notes, however, that short-term government bonds are used by many market participants as collateral, which means that they are in high demand. “If you look at all European investments, short-term government bonds are not very attractive. There are better alternatives available if you compare the compensation with the risk.”
Nevertheless, according to Van Noorloos, there is definitely room for government bonds in the investment portfolio of pension funds.
“They can still be used as collateral for the interest rate hedge. So we do not recommend divesting from government bonds altogether, but we do recommend investing much less in the category.”
Opposing views
Some other asset managers, however, such as Columbia Threadneedle Investments, are of a different opinion.
“There seems to be a kind of generic view in the market that pension funds will invest less in government bonds,” acknowledges LDI strategist Jan Willemsen. “But I don’t see that with our clients, who are actually planning to invest more in government bonds from the countries where they are already invested.”
Willemsen explains: “Pension funds have a lower interest rate hedge and need less collateral for interest rate swaps. As a consequence, funds have money left over. So in my view, more capital ends up in government bonds, or possibly in short-term corporate bonds.”
Colombia Threadneedle points out that relatively safe government bonds, with an AAA-rating like Germany and the Netherlands, have a higher interest rate than swaps.
“That was different a few years ago. So it would be strange to sell those loans at a loss right now. Moreover, in the short term, government bonds pose a basic risk compared to swaps, but we should not suddenly pretend that government bonds are unsafe investments,” says Willemsen.
Edwin Massie, investment consultant at Ortec Finance, has noticed that Ortec’s pension fund clients are more in line with BlackRock’s view, reducing the percentage they invest in government bonds within the LDI portfolio.
“Funds are bringing the weight of AAA government bonds back to the level needed to meet their collateral and liquidity needs,” he says.
But Massie also points out that the interest rate on long-term government bonds of the Netherlands and Germany indeed is now above the swap rate.
“That could be a reason to hold more government bonds than previously thought,” he says.
This article was first published on Pensioen Pro, IPE’s Dutch sister publication. It was translated and adapted for IPE by Tjibbe Hoekstra.
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