As well as trying to mind-read Central Bankers, poring over economic statistics and keeping a keen watch on world events, investors also need to be more than up-to-date with all sorts of rules and regulations, dull though they may be.
In a recent piece of careful and thorough research from ABN AMRO, rates strategist Harvinder Sian has been looking at the impact of forthcoming regulation changes in the Dutch pensions’ market, and has concluded that investors need to sit up and take notice.
“Pension fund regulations will continue to evolve in Europe, not just in the Netherlands but also, significantly in France and Germany,” states Sian. “What I have tried to do in this research is focus on Dutch reforms not least because we believe that the regulatory changes will start affecting investor behaviour during the coming months. Portfolio allocations will be shaped by these changes and we expect to see investment flows through the first part of this year, gaining momentum as we go in to the second half of 2004.”
Sian’s central premise is that the long end of European government bond yield curve will endure a structural flattening process as a direct result of these changes. Although he does draw certain comparisons with other bond markets where regulatory changes have had significant impacts on bond markets, he is anxious not to be misinterpreted. “The UK’s gilt market – where long gilt yields now trade though 10-year – is a very extreme example, and there are very significant and obvious reasons which contribute to the curve inversion. We do not have those conditions in the Netherlands. However, what happened in Denmark is relevant for clues as to what yield curve changes, if any, we might expect.”
In Denmark, the fall in equities in Q4 2001 caused large flows in to the long end of the European bond market as funds were compelled to address deteriorating solvency conditions. Using regression analysis, Sian calculates that the Danish experience seemed to cause a structural flattening in the 30 year to 10 year yield spread (30Y-10Y), although even here he is careful to add the caveat that ‘9/11’ may also have had a lasting impact on the 30Y-10Y.
“The solvency issue is certainly relevant to the Dutch situation,” asserts Sian. He points out that the regulator is looking to put in place three key elements for shoring up the solvency of the Dutch pension system namely: minimum funding requirements; stress testing; and financial buffers.
Sian argues that while all these factors will be important and should encourage moves into bonds, he and his colleagues do not foresee a huge shift from equities into bonds. “Moving from actuarial valuations to marked-to-market valuations of liabilities should also, on the face of it, encourage funds to asset switch from equities into bonds. However, cutting back on risk-taking does however have a very important trade-off in the prospect of lower expected returns which of course is pretty unappealing, especially with bond yields so low at the moment.”
Where Sian does predict significant moves by the Dutch pension funds is within those funds’ existing bond allocations. “The new regulations and market valuations of liabilities are likely to produce a shift in the duration exposure of the (pension fund) sector. This, for us, is the big story.” According to the Dutch Central Bank and available industry sources, the average duration of liabilities in the Dutch pension fund sector is close to 15-years. For the asset side, Sian explains that there are no reliable data on the current duration of the pension sector’s bond holdings so argues that a benchmark, such as the IBOXX index should be a good proxy. The duration of this particular index, which contains euro denominated government bonds, sub-sovereigns, collateralised, covered and corporate paper, is around five years.
“So the duration gap is close to 10-years. Shifting bond portfolio durations by this degree implies switching from 7-year maturity bonds into 30-years and longer. If we try and make some conservative assumptions about the actual amount of Government bond holdings in the Dutch pension fund sector– a 35% allocation in bonds overall, of which perhaps 2/3 is in Government paper –we reach a figure of at least E110bn. A shift in such a sizeable bond holding towards higher duration assets should motivate a significant richening at the long-end of the curve.”
So it’s clearly a question of when, not if, these flows will happen causing the 30Y-10Y to flatten. The new regulations will be encapsulated within the Financial Assessment Framework (FTK) which is due to come into effect on 1 January 2006.ABN AMRO understand that a draft paper of the FTK will be published in March/April 2004, after which a two to three month consultation period would be envisaged. The regulator currently assumes that 2005 would see an implementation period for the FTK.
Sian concludes, “We do not expect front-running of the draft FTK, particularly given an understandable reluctance to buy bonds at historically low yields. After March/April, however, investors will have more facts to hand such as the actual rate to be used to discount liabilities (bonds or swaps?). We expect some pension and insurance funds to start moving over the second half of the year, making the reasonable assumption that the final shape of the FTK will not be too different to the post-consultation version.”

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