NPRF separates commodity risks

The default of swaps provider Lehman Brothers in October 2008 sent shockwaves through the investment community and made some investors re-examine their commodity swaps positions.

One of those affected was Ireland's National Pensions Reserve Fund (NPRF). With a benchmark allocation of 2% to commodities and forestry, it currently has all its commodities exposure by way of structured notes. It previously had a structured note with Lehman Brothers, which matured in June 2008, terminating the commodity exposure just months before the bank filed for bankruptcy.

"We had already decided by June that we did not like the counterparty risk that comes with structured notes," says Ronan O'Connor, head of risk and asset allocation at the NPRF. "We had invested in Lehman's through fully funded notes - meaning we paid the bank the full amount of our exposure so it would operate in the futures market to replicate the S&P GSCI and it also managed the collateral - so if we had had the exposure when it filed for bankruptcy we would have been an unsecured creditor. We were actually in the process of setting up a segregated account with Lehman's when it went bankrupt."

When the NPRF started its current structured notes in 2005, its in-house policy was that the credit risk of the counterparty had to have a minimum rating of single -A. "Back then the credit ratings of the big banks we were dealing with were regarded as extremely sound," recalls O'Connor.

"We are now letting the outstanding commodity notes we have with a number of other counterparties - two of which are members of the Troubled Assets Relief Program (TARP) and have raised money, and another has been taken over, resulting in improved credit ratings for all three - roll off because they are effectively unmarketable and will mature over the next two and a half years. They are over-the-counter products and therefore we would have to go back to the issuer and redeem. If we redeemed early we would be liquidating at a loss relative to the benchmark because the issuers' credit margins have increased. Nevertheless, if their credit rating fell further we might consider selling the paper."

O'Connor adds: "We are not going to invest in commodities via structured notes again. Our trustees have instructed us that if we want to take credit risk we can buy paper. But if we want to have commodity exposure there should not be any counterparty risk attached to it. In other words, credit risk and commodity risk should travel separately. So any new commodity exposure will be by way of either algorithmically traded funds or segregated accounts, where we dictate the terms on which the commodity exposures are replicated. In short, we will insist on having the collateral managed separately.

"The main risk mitigation is to have the collateral managed in a nominee account belonging to us. Another risk control is to allow the manager limited tracking error versus the index we want to replicate. By investing in funds or segregated accounts we can force managers to produce the exposures we are looking for. And if they fail to replicate then they can be terminated."

The NPRF is still unsure about the future with regard to collateral.

"If we were to look at collateral right now, we would specify US T-bills," says O'Connor. "But as the financial environment improves we may loosen the collateral requirement to some extent. However, in the future we will still be looking for AAA-type collateral."

The NPRF is due to look at its commodity portfolio in the first quarter of 2009, with another of its structured notes due to mature early this month.

"Amid the expiry of the notes, we are underweight in our allocation so we will re-invest in commodities under the new arrangements," says O'Connor. "Over the past three years our commodity investments have done exactly what we expected them to do. They have shown negative correlation with other assets in our portfolio and we are perfectly happy with them as an asset class."

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