On the Record: The question of hedging
We asked two European pension funds how they hedge against interest rate risk, as the probability that interest rates will rise over the few next years grows
Dynamic and diversified
Our hedging strategy is based on a dynamic interest-rate ladder construct. That means we will lower our interest rate hedge almost automatically if interest rates fall. Currently, we hedge 40% of our interest-rate risk. We base our dynamic interest rate-hedging strategy on the 30-year swap rate, and when that rises above 2% we will increase our hedging level to 50%, in accordance with our policy. This is the default process that is part of our long-term investment strategy. However, we are not bound by it. We can maintain hedging as it is or change the hedge ratio, depending on our view, but we need to have good arguments to deviate from the dynamic-hedging strategy. By the default, we will follow the strategy.
We do not expect interest rates to rise to a significant extent next year. Growth is still weak and we could see an economic slowdown in the coming years. Furthermore, core inflation is still low. Adding it all up, we think the European Central Bank is unlikely to raise rates next year. In fact, rates could even move the other direction. We could see the market trending downwards and investors seeking safety in government bonds.
Our matching portfolio is diversified. We hedge short-term liabilities with investment-grade corporate bonds. Moving up the liability curve, we hedge using Dutch mortgages, which are typically AA-rated and still offer a very interesting spread. Further along the curve, we hedge with Dutch and French government bonds and swaps.
Many pension funds in the Netherlands have invested in Dutch mortgages through several funds that have been launched and grown significantly over the past few years. Mortgages are mainly used as a matching assets.
Corporate bonds are often used as a hybrid asset, both for matching and return-seeking purposes. We use investment-grade corporate bonds only as a matching asset, as it mimics our liabilities quite well and allows us to earn an additional spread. The additional spread helps us to bridge the gap between the ultimate forward rate and the swap rate.
Taking a long-term view
The way we approach liability-driven investment (LDI) is informed by the regulatory environment our pension plans are in. There is a difference between operating in an environment where a regulator requires minimum funding levels and one where we can take long-term views about interest rates. Our pension scheme in Ireland, for instance, has funding requirements, and we have always kept a good degree of interest-rate hedging in those plans. The Irish scheme is about 100% funded, according to what is known as the funding standard liability measure, which is calculated using fixed discount rates for different member groups. That translates into an economic hedging level of only around 40%.
In Germany, the main pension plan is a contractual trust arrangement (CTA) from a legal perspective and has no funding requirement. In that plan, we have never had a hedging level over 35% and we have quite dramatically reduced it over the past few years. The hedging level in that plan is very low at the moment at around 10%.
We do not seek a higher hedging level because the regulatory environment allows us to take a longer-term view. On the balance of probabilities, we think it is more likely that yields will rise than they will fall. If that is the case, then we should not be hedged to a high degree, because if rates rise we will lose money. We cannot be certain that rates will rise, considering the risks such as Italy’s debt situation and the fact that the euro-zone is somewhat unstable. That is why we still maintain some hedging. However, if we had more certainty that interest rates would rise, we would reduce the hedging level to zero.
Euro-zone yield curves are still steep. If short-term rates rise, that will be a welcome development, because floating-rate assets will give us better returns, and the hedging cost for US dollar assets will be lower. At the same time, long-term rates might not rise to a great extent. In general, however, our view has always been that hedging only makes sense if there is a risk of rates falling further. Why hedge at all if one believes rates have bottomed out?
Consultants and asset managers tend to argue that hedging should be kept at a high level at all times. Their argument seems to be driven by a particular view on the rationality of markets. If one believes markets are rational and always capable of predicting the future level of interest rates, then you should hedge to a high degree. However, I do not think it is that simple. It is difficult to predict the exact level of rates over a short time period, but it is possible to attach a probability that rates will be higher a number of years into the future. If you can take such long-term positions, then it makes sense to do so.
Besides that, hedging is a costly activity and it is easier the further removed one is from the company to argue that it is worthwhile. In our Irish plans we only have government bonds and swaps in the hedging portfolio. For our German and UK plans we look at the structure of cashflows to help us determine our asset allocation. This means we will look at assets other than government bonds and swaps to hedge our liabilities.
Interviews by Carlo Svaluto Moreolo