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Play your swaps cards right

There are still opportunities at the right price for investors looking to hedge their risk via swaps. But, as Gill Wadsworth finds, they must take great care over timing and choice of counterparty 

The need to eradicate risk from pension portfolios has never been greater. But retirement plans eyeing swaps as a potential solution could find that the markets have become prohibitively expensive.

As the global financial meltdown continues, spreads on inflation rate swaps at the shorter end of the curve have widened considerably; whereas two years ago spreads were in the region of 2-3 basis points, they had reached 20bps in October.

Andrew Welch, head of institutional client service at Insight Investment, says the spreads on pure inflation swaps, particularly on short-dated inflation are "higher than I have ever known them". This is bad news for pension schemes looking to hedge this risk from their portfolios.

Welch adds: "There is no question that the markets have become less liquid and more expensive to trade in."

The industry has been quick to blame the collapse of Lehman Brothers in September for the rising costs of swaps. The demise of the investment bank triggered a flood of pension schemes and insurance companies in the market looking for a replacement counterparty.

In the days following the bank's default, bid/offer spreads widened dramatically but the failure of Lehmans is just one symptom of the much wider financial crisis which is driving up costs on the swaps market.

Max Verheijen, managing director at Cardano in the Netherlands, says: "The Lehman trades have been transferred to a large extent to other counterparties and we saw some shocks in the market when those transfers took place. There were intra-day shocks, but the continuous pricing situation on the swaps market is to do with the financial crisis itself."

The scarcity of liquidity in the markets caused by the wholesale deleveraging by banks and hedge funds has been the primary driver of costs in the swaps market. In addition, the number of banks that are willing or able to take part in the derivatives market is dwindling. This means issues of supply and demand are having an impact on price.

Robert Hayes, head of the strategic advice services team at BlackRock, says: "We have seen a lack of supply leading to swap prices rising relative to government bond prices."

There is also a much greater awareness of risk on both sides of the swaps deal, which has pushed up costs. On the one hand, pension funds are taking greater care and time over collateral management, which brings its own set of costs for the schemes and for their fund manager. On the other side of the deal, the counterparties are pricing their own heightened sense of risk into swaps deals.

Tony Osborn-Barker, global head of pensions advisory at BNP Paribas, says: "People are realising that a swap, to all intents and purposes, can be a 50-year loan to a pension scheme which has credit issues. While it is a funded entity, by definition all pension funds are insolvent to begin with, so if I am making available a 50-year line of credit I am going to want to charge for that facility."

And this approach is not limited to BNP Paribas; across the board banks are showing reluctance to take on counterparty risk and where they do enter into deals, their reticence is reflected in the pricing.

Cardano's Verheijen says: "The risk budgets have decreased within the banks so it's not as easy anymore to transfer a whole lot of interest rate sensitivity from the pension fund to the bank as it used to be."

In spite of the undoubted expense of entering the swaps market, particularly within inflation hedging, there are ways in which investors can avoid bearing these costs in their risk management strategies. Investors who were forced out of the swaps market when Lehman Brothers collapsed may not need to re-enter the market immediately at a time when they will incur higher costs.

Hayes says: "The question is, do you want to replace that hedge position straight away, in which case you are in the market environment where there are wider spreads, bigger dealing costs and there may be poorer liquidity? Or do you just say ‘I would like to hedge this risk but I am not in a tearing hurry to do so'?"

He adds: "From the pension fund point of view, you need to disentangle between the strategic importance and immediate trading urgency, and not get caught up in an expensive trading when you may be able to take a more strategic view."

Given the current market environment it might be cheaper for pension funds to look at hedging their risk using alternatives to the swaps markets, such as reverting back to more traditional securities. At a time when governments will be forced to issue millions of euros-worth of bonds to pay for their bailout packages, the markets are set to be flooded with government paper, which could make them a cheaper proposition.

Insight's Welch says: "Where you have got the capital to deploy, making the best use of gilts and index-linked gilts as a means of hedging interest rate and inflation sensitivity has made a great deal more sense in recent weeks than doing it through the swaps market."

However, the widespread use of traditional asset classes as an alternative to swaps is likely to be a temporary phenomenon and pension funds  should only take these tactical decisions if they are in a position to act quickly when the market changes.

Welch adds: "It is very important to think carefully about how you structure solutions. You need to be able to take advantage of big anomalies in the market and then be in a position to unwind if swaps spreads became attractive again."

Investors should also bear in mind that rising costs have not affected the entire spectrum of swap arrangements. For example, while dealing at the front end of the inflation curve has become very expensive, the long-dated end looks attractive. Spreads at the 40 to 50-year mark are back down at around 2bps; a huge difference from the 20 or so basis points at the short end.

Welch says: "Spreads can be from 30 down to 2bps depending on where you are in terms of structure and what you are trying to trade."

In spite of all the upset on the financial markets and the rocketing costs of some swaps, the derivatives markets have been more active than ever before. In a survey of 60 traditional investment houses and hedge funds, consulting company Morse found that since 2007, 64% had increased their trading in derivatives on the back of demand from institutional investors. The research found that interest rate swaps account for 65% of the total derivative trades, but credit default swaps rose by a staggering 107% in the past year.

This level of activity indicates that pension funds still view swaps - both plain vanilla and more complex instruments - as critical to risk management and that escalating prices is not enough to deter them from entering the market. Cardano's Verheijen says he has seen a continued demand for liability driven investment strategies which are heavily reliant on swaps as part of the hedging element, while Osborn-Barker says BNP Paribas is seeing a new European pension fund client every week.

However, while appetite for derivatives remains strong, pension funds are changing their approach to the swaps market and rethinking how they structure deals and manage risk. The obvious area for attention is collateral management which is likely to require daily attention from funds and their investment  managers. But there will also be a greater emphasis on the role of investment consultants in how they understand the swaps market.

With the number of anomalies in today's investing environment and the need to think smarter about entry points and pricing, scheme advisers will be under intense pressure to demonstrate their strength in the derivatives markets.

Verheijen says: "You need to be very careful about implementing the structures. If you do it in the wrong way you are going to influence your own market negatively. You should be more careful in execution methods and in choosing your counterparties, and it is very important to have a good legal framework."

Doubts remain, however, about some consultants' ability to operate effectively in the swaps markets. Osborn-Barker says it is not clear that the investment consultant community has a sound understanding of capital markets pricing, nor about the right times to enter or exit the market.

"The challenge is for the advisers and consulting community to understand all the risks," he says.

Swaps are unique in their ability to hedge inflation and interest rate risks so precisely and as such, they will remain critical for pension funds as they de-risk their portfolios. Like everything else in the financial markets, dealing in swaps has become more difficult and expensive, but for investors with the right understanding and appropriate support there are still opportunities to be found at the right price. 

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