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Netherlands: The bond-to-swap trade

• QE is depressing yields on euro government paper
• Dutch pension funds are picking up a yield premium by using swaps
• Timing issues will arise in 2018 as the ECB tapers purchases

Dutch pension funds are increasingly switching from physical government bonds to interest-rate swaps, given that 10-year swaps have been trading above 10-year government bonds for some months. 

As of early December, 10-year euro swaps were trading more than 40bps over the yield on Dutch or German 10-year bonds, as a result of the European Central Bank (ECB) purchasing programme, a situation which has persisted for some months. Under normal conditions the two move much more closely. In the case of 30-year paper, swaps are trading more than 25bps over government bonds.

For a pension fund, the yield premium is the main reason to purchase interest-rate swaps at the expense of government bonds. The scheme receives a higher swap rate from the counterparty and pays a lower floating rate, the three-month EURIBOR. To be able to pay the bank the variable rate, the pension fund buys equivalent money-market paper. 

Loranne van Lieshout, pension consultant at Ortec Finance, says a limited number of pension funds made the switch from government paper to interest-rate swaps in 2017. She also notes that the topic is under discussion at a number of funds.

Is there still time to capitalise on this premium? In mid-2015, shortly after the ECB started its purchasing programme, 20-year swaps also yielded more than safe euro-denominated government bonds. This suggests there is still time.

Van Lieshout says it might have been better for funds to have already acted. “But pension funds have tactically responded less and less to developments such as the ECB’s quantitative easing programme. And implementing strategic changes of an investment policy is a slow process.Moreover, the swap rate is still higher than the expected returns on government bonds. The rationale for the switch still applies. If the ECB scaled down its purchasing programme, government bonds would probably take a bigger hit than interest swaps.”

According to van Lieshout, it could still be useful to replace government bonds with interest swaps combined with investments in money market funds if the ECB were to reduce quantitative easing (QE) and interest rates rose.

10 year euro swaps

“Most pension funds have already significantly invested in interest swaps as a hedge against interest risk on their liabilities,” van Lieshout continues. “If interest rates rose, they must free liquidity as collateral. Counterparties increasingly demand cash rather than government bonds as collateral, in part as a consequence of regulation such as EMIR and Basel III. As a result, the need for liquid assets increases.”

Van Lieshout underlines that increased swap holdings would also require more collateral if interest rates were to rise. But this would involve relatively small amounts, in particular relative to the amount that a pension fund would free up if it divested from government bonds.

Replacing government bonds with interest-rate swaps could lead to substantial shifts in fixed-income portfolios. “Sometimes more than 10% of government bonds is being divested,” van Lieshout says. “These are really significant amounts.” Nevertheless, the switch will probably not appear in the official statistics of supervisor De Nederlandsche Bank (DNB) as interest-rate swaps and government bonds are often managed in a single mandate.

At Cardano, which manages about €9bn in combined mandates for about 25 pension funds, the switch to swaps has been much greater than 10%. From the beginning of the ECB’s QE programme, it has sold batches of long-dated government bonds in favour of interest-rate swaps in combination with investments in money market funds and short-dated government paper, trading with several banks for the interest swaps.

Rik Klerkx, portfolio manager at Cardano, says: “For all mandates combined, before quantitative easing, we hedged 80% of the interest-rate risk through government bonds and 20% through interest swaps. In the meantime, this ratio has changed to 10% government bonds and 90% swaps. The risks on long-dated government bonds are simply too great for their potential returns.” Klerkx points out that his discretion on the ratio between swaps and government paper is agreed in advance with the individual pension funds.

Given that the ECB will taper, Klerkx is assessing whether it would be sensible to change direction, with a lower proportion of swaps and money-market paper and more in long-dated government bonds. “We will have to be careful and certainly refrain from making big steps. Yields on government bonds must improve first anyway,” he says.

 “The interest-rate risk remains the same so there is no impact for the required own assets,” Klerkx continues. “However, you need to take into account that, once you sell the swaps, you have to replace them with AAA-rated bonds. If you opt for AA paper, for example from France, your credit risk would increase.”

Klerkx also notes that adding swaps to the portfolio reduces a pension fund’s interest-rate risk. “The fine-tuning of assets relative to liabilities improves, as liabilities are discounted against the swap rate, whereas the yield on government paper is used as the discount rate for government bonds. The larger the proportion of swap holdings, the larger part of the assets can be discounted against the swap rate.”

Is ramping up investments in interest swaps fully risk-free? Ortec’s Van Lieshout points out that money market funds would possibly be less liquid during periods of stress on the financial markets. This could result in pension funds having less easy access to cash as collateral when interest rates rise. “But this would in particular apply to money-market funds that offer a relatively high interest-rate compensation, resulting in increased credit risk.”

Van Lieshout says: “In addition, investing in derivatives, such as interest-rate swaps, always carries more risk than investing in government bonds. Think of counterparty risk, valuation risk and operational risk. The switch from government bonds to interest-rate swaps only makes sense for pension funds that already are in control of these risks.

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