GLOBAL - Pension funds have been lining up to take profits from the interest-rate swaps they have put in place for liability-driven investing (LDI), according to their fixed income managers and advisers.
"A number of clients have cashed-in their swaps and bought index-linked gilts instead," said Chris Helyar, a partner with Lane, Clark & Peacock. "You'd have made a lot of money doing that at the back-end of 2008."
"The opportunity was at its peak in January, but it's still there," added James Morgan of KPMG's investment advisory division. "It's been very, very beneficial."
The opportunity arises when the swap rate falls below the government bond yield at its equivalent place on the yield curve - which is highly unusual, since the swap rate normally represents exposure to the risk-free rate plus a small Libor spread for bank credit and counterparty risk.

But since last autumn the phenomenon has been spotted on the euro, sterling and US dollar curves.

Explanations range from the Lehman brothers bankruptcy leading to the termination of contracts, which set off a scramble to replace them in a market where banks were scaling back operations; through excess bank liquidity and punitive funding costs in cash gilt markets; to concerns about government creditworthiness in the face of huge imminent issuance of bonds.
Some pension funds are closing down their swaps positions altogether, in exchange for government-bond forward contracts. This locks in the higher bond yield but also exchanges the Libor funding of the swap for the much lower overnight-repo funding of the forward. Other funds are "re-couponing" their swaps - closing down one and opening another.
Both moves are releasing significant profits for some schemes, which many have ploughed into nominal and index-linked government bonds, again picking up extra yield while removing bank counterparty risk.

Other funds are being even more creative, buying government bonds and then implementing asset swaps to exchange the bond return for Libor plus the return from the contraction of the negative swap spread.
"They've locked-in in the profit of Libor+100bps on the initial movement in the swap curve, and now, as the curve moves back, potentially they can unwind that position and take another profit - a profit on a profit," said SSgA's head of LDI, Joe Moody. "Investors have seen their asset-swap positions move to profit quite markedly, having just taken the profit from the negative spread."
The announcement of quantitative easing in the US and UK helped to generate some of that second profit, as the negative spread narrowed almost to parity from extremes of -70bps or more. But few are willing to say that the window of opportunity has closed.
"The launch of QE did bring that swap spread almost back to zero - but it's been enormously resilient," said Hewitt's Tapan Datta.
The spread under the UK yield curve all but disappeared until Chancellor Alistair Darling's Budget and resulting concerns about government creditworthiness helped push it out again in the last week of April.

Further analysis on this subject will be published in the June edition of IPE.