EUROPE - Pimco, the asset manager, has suggested pension funds who were considering applying an interest rate swap to their portfolios should instead look to a gilts overlay or equity futures to gain better returns.
Jeroen van Bezooijen, senior vice president and LDI product manager at Pimco, said pension funds looking to protect against interest rate risk on their fixed income returns could do so without buying now expensive swap products and instead look to either the repo market or use equity derivatives as part of the fixed income strategy.
More specifically, he noted the long-term swap rate is now lower than can be earned on long-term gilts but pension funds cannot practically sell out of equities to buy bonds and hedge liabilities without making further losses on investments.
In earlier market conditions, the difference between buying swaps and gilts was in the region of 0.5% but van Bezooijen noted there is now a gap of at least 1%, making swaps seem out of reach to pension funds because of their expense.
"Six-month Libor is an indication of where banks lend money to each other. One of the things we have seen over the last 6, 12, 18 months is that six-month Libor is not a risk-free rate. It has been as much as 2% over the Bank of England base rate, but is now at around 0.8% higher," said van Bezooijen.
"The fixed part, if you look at the 30-year maturity, has a swap rate which is 0.4% lower than the 30-year gilt yield. In normal market conditions, we would expect it to be between 0.2% and 0.4% above gilt yields, and on the other side the floating-rate is 0.8% above the risk free rate, against a more usual 0.2-0.3%. Combined, that's over 1% difference."
He continued: "Whereas pension fund would typically hold 50-60% equities and 40% in gilts, if they want the strategy to be closer to liabilities, what they typically did is hedge with swaps and keep assets in equities, because they still need that return. [Pension funds] are still very much in that situation where they can't fully afford to sell out of equities and buy gilts. But rather than doing it through swaps, there are two other ways they could go," said van Bezooijen.
Pimco suggested it is possible to use the gilts repos markets to apply a gilts overlay without needing to invest the full assets in gilts.
Instead, much in the same way as swaps, the pension fund can buy gilts and finance this purchase by borrowing against that gilt in the repo market so it gains the exposure to long-dated gilts, but without the need to pay the full price for that exposure.
Similarly, pension funds could also place an equity overlay on the fixed income portion of the scheme and hold mainly gilts in the portfolio, but gain further exposure to equities at a much better price.
"Because people have a set way of thinking, pension funds have equities because they want the [returns] exposure. But you can also get the equity exposure through the derivatives market," said van Bezooijen.
"Equity futures, in historical terms, are relatively cheap compared to equities. And you end up with a portfolio of mainly gilts, but add equity exposure using derivatives. The end result is a very similar exposure.
"It is just one of those times where you have to look at what you are trying to achieve. It doesn't need to be the case that if you want to hedge your [pension] liabilities you have to use swaps. There are other options," he added.
Van Bezooijen's comments were made in response to an earlier claim by F&C suggesting pension investors should consider swaps over gilts right now to gain better returns. (See earlier IPE story: Swaps should be favoured over gilts - F&C)
Yet the Pimco view was also echoed today at a Lane, Clark & Peacock pension briefing.
Speaking in London today, Clay Lamboitte, partner of the investment practice at LCP, said pension funds looking to reduce their risk exposure have other options than the less liquid gilts market.
"Rather than parking the idea of reducing risk to one side, just because of a lack of liquidity in the swaps market, you can replace equities with bonds plus equity futures," said Lamboitte.
"We can increase your allocation to the matching assets, while maintaining your exposure to the equities product. And it doesn't require the upfront capital. It is cheaper and more liquid than swaps," added Lamboitte.
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