Structures that promise yield boost
Few classes of investor have been more resistant to the imprecations of derivatives sales teams than pension fund managers. While the use of plain vanilla instruments for asset allocation purposes, or to hedge exchange-rate risks, is now relatively common, the majority of managers have shied away from investing in derivatives in their own right.
Derivatives have long been associated with dizzying complexity, and – on occasion – dizzying losses, where managers have failed to fully understand the risks associated with the structures in which they invest.
But times have changed since the misselling scandals of the early- to mid-1990s, where some institutional investors found themselves carrying massive losses on structures they were woefully ill-equipped to comprehend. Derivatives dealers insist they are now much more rigorous in determining the suitability of structures to client needs. And increasingly sophisticated pension fund managers are growing less chary of the ‘d’ word.
Attitudes towards derivatives vary across Europe. The UK system, where plan sponsors are responsible for overseeing the funds, but not for taking investment decisions, encourages conservatism. Even where mandates exist to use derivatives, investment managers usually shy away, dealers say.
Dutch pension funds, in contrast, are often self-administered, giving fund managers more leeway in determining which instruments they use. And, given the huge size of some Dutch funds and the small size of the pre-euro guilder capital market, fund managers have been forced to be more creative to generate returns. This creativity has long expressed itself in the enthusiastic use of interest-rate swaps, for example. In France, too, derivatives use has enjoyed greater acceptability among pension funds, boosted by recent regulatory loosening.
But dealers predict that the increased focus on credit as an asset, following the introduction of the euro, will encourage pension funds across Europe to increase their use of derivatives. A key driver is demand for higher yielding corporate credits. A single A-rated corporate bond currently pays around 60 basis points (bp) above comparable government bonds in the euro market, and offers a 150bp pick-up in the sterling market. However, liquidity in Europe’s corporate bond market is often thin.
This problem is generating interest from pension funds in credit derivatives. These ‘synthetic credits’ can offer investors exposure to hard-to-find names, says Gareth Derbyshire, London-based vice-president in Morgan Stanley Dean Witter’s European pensions group.
Credit derivatives transfer the credit risk from one party to another, without transferring the ownership of the underlying bond or loan. So, with no requirement to find the underlying bonds, such notes can be issued in sizes of between E500m and E1bn.
The instruments are usually structured as credit-linked notes – structured notes (that is, tradable fixed income securities) with an embedded credit swap. A credit swap essentially pays the buyer the performance of the underlying credit or basket of credits.
Or they can be used by pension funds to gain exposure to credits at levels that meet their benchmark. For example, a pension fund may want to buy a corporate name in the sterling bond market that pays its benchmark return of gilts plus 125 basis points. Due to the scarcity of the bond, it may only be available in the secondary market at gilts plus 100.
However, derivatives dealers are able to strip the credit risk from more complex, illiquid transactions, such as project financing deals. This risk is then packaged up into the credit-linked note.
Investors should ensure, however, that the synthetic credit mirrors the risk of the underlying. Some credit derivatives, for example, can be ‘triggered’ by credit events that wouldn’t affect a holder of senior notes issued by the company.
Some pension funds are also using derivative structures as a point of entry to new, higher-yielding asset classes. The growing correlation of global bond and equity prices is encouraging funds to look to alternative investments – such as hedge funds, as reported in IPE in February.
Hedge funds traditionally deliver high returns – with corresponding levels of risk – by using unconventional investment strategies. Many of these strategies are market-neutral, offering returns regardless of the direction of underlying markets.
However, as high risk investments, individual hedge funds have proved unattractive to pension fund managers. An alternative is to invest in diversified funds-of-hedge-funds. By taking stakes in anything up to 60 hedge funds, these funds-of-funds provide lower risk (and commensurately lower returns). The implied volatility of a typical fund-of-funds will be around 8–10% per annum, compared to the FTSE’s volatility of around 23%. Such a fund will return 7–15% per annum, as opposed to the 15–25% return of a single hedge fund, say dealers.
Unsurprisingly, pension fund managers are proving reluctant to make outright investments in this new asset class without first testing the water. Investment banks are therefore offering principal-protected hedge fund products to encourage investors to dip a toe in the market. Packaged as structured notes, the instruments, which are typically five to 10 years in maturity, can take a wide variety of forms depending on the investor’s preferences.
One way of structuring the transaction is to use a combination of zero coupon bonds and a call option. The majority of the investment will be used to buy zero coupon bonds. At maturity, these bonds will have accrued sufficient interest to repay the principal. The remainder of the investment will be used to buy a call option on a fund-of-funds – conferring the right, but not the obligation, to
buy a pre-specified amount of the fund, at a pre-specified price.
However, these structures can limit investors’ upside participation. In times of high interest rates, a relatively low proportion – say 70% – of the investment can be invested in zero coupons. But, in the current low interest rate environment, zero coupon bonds are more expensive, meaning that less money is available to buy options on the fund-of-funds.
Structures where the principle is initially 100% invested in the fund-of-hedge-funds have therefore become more popular. These are structured with periodic trigger points where the fund’s performance is assessed, and if the fund has underperformed, a percentage of the investment is moved into cash. This cash component (which is interest-rate swapped, thus effectively mirroring the pay-out from a zero-coupon bond) ensures that the principal is repaid at maturity if the fund-of-funds performs poorly.
Chris De Marco, director UK and Ireland investor marketing at Credit Suisse First Boston in London – which offers a principal-protected hedge fund product called SAPIC – expects that, given time, pension funds will take direct investments in hedge funds. In the meantime, these provide a stepping-stone, he adds.
Going forward, this drying-up of government bond issuance could see more pension funds looking to interest-rate swap structures as a way to enhance fixed-income returns. Over the past six months, swap spreads have exploded, driven by government debt buy-back, and periodic flights to quality, most recently caused by the technology stock sell-off.
In early April, a 10-year sterling interest rate swap with a double-A rated counterparty was paying 110bps over gilts – compared to historic lows of around 30bps.
Whereas the large, sophisticated Dutch pension funds may be happy to transact interest rate swaps directly with bank counterparties, other pension funds – particularly in the UK – are likely to prefer embedding swaps in structured notes, dealers believe. Such notes allow investors to specify the coupon, size, and maturity of the swap, which is then transformed into a tradable security.
But while the use of derivative products remains limited, dealers in the UK are hopeful that domestic pension funds will turn to complex options products to boost returns if their fixed income assets outperform.
Demand could be driven by changes to the Minimum Funding Requirement (MFR), a solvency test created by the Pensions Act 1995 and now under review. Most UK funds run a mismatch between their asset and liability mix – being typically overweight domestic and overseas equities, and underweight UK bonds and index-linked gilts. If the fixed income component of the portfolio outperforms the equity part, funds with a low asset/liability ratio (say, 110% of assets to liabilities or below) run the risk of falling foul of the MFR rules.
A few of the more adventurous pension funds have therefore bought complex ‘outperformance options’ to hedge this risk. The ideal structure would pay out when a combination of conventional fixed-income and index-linked bonds outperforms a mix of UK and foreign equities.
However, the lack of a derivative market in index-linked gilts, and the difficulties of structuring derivatives linked to the correlation between assets, means that the deals structured thus far have taken a more simplified tack, for example by focusing on the outperformance of conventional gilts against foreign equities.
“Once the question of the MFR review has been resolved, there may be more scope for these structures,” says MSDW’s Derbyshire. “It’s a means by which funds can address the MFR risk without changing their long-term asset strategy.”
However, using derivatives to enhance yield remains the exception rather than the rule. Dealers say that most fund managers are happy to take longer-term market views, in keeping with their long-term liabilities, and are usually happy to ride the ups-and-downs of stock and bond markets without dabbling in derivatives to boost returns – especially given the perceived complexity of many derivative products.
Mark Nicholls is editor of ‘Environmental Finance’ in London