Nina Röhrbein looks at the growing area of swap indices and their application within liability strategies
When Barclays Capital launched its swap indices family this year- comprising both nominal and inflation swap indices that incorporate both zero-coupon and coupon-paying/real rate swaps - it joined Lehman Brothers and Merrill Lynch in the select group with that type of offering.
The development of these indices was a natural but also popular step, according to Barclays Capital.
"When pension funds design and award investment mandates, they define the return as well as the portfolio profile," says Serkan Bektas, head of Barclays Capital's pensions solutions group. "And the way they communicate this to their asset managers is via the establishment of a benchmark index. As the use of interest rates and inflation swaps within pension portfolios has grown very rapidly, we wanted to provide an industry-standard benchmark that can be utilised by pension funds to set swap-based mandates.
"And over recent years we have encountered demand from clients for information to benchmark the performance of their asset managers. We had already been supplying this data to specific clients for a number of years but amid increased demand we decided to make this type of index publicly available."
"We have a widely adopted family of inflation-linked government bond indices that has been utilised to establish liability-driven investment mandates and so the synthetic or swap indices were a natural compliment to those cash-bond indices," says Waqas Samad, head of index products at Barclays Capital.
The main function of these swap indices is to provide a comprehensive set of building blocks to pension funds, their consultants and LDI managers who can weight them appropriately to construct custom benchmarks according to their exposure, he explains.
"One of the shortcomings of using cash-bond indices for LDI purposes is the mismatch between the liability profile of the fund and the cashflow profile of the benchmark bond index," Samad adds.
Lehman Brothers developed the first coupon-paying swap indices designed as building blocks to replicate cash-bond indices in 2003, according to Lee Phillips, head of indices and portfolio management tool marketing in Europe at Lehman Brothers.
"Due to the advent of liability hedging by pension funds there was increasing demand from clients and consultants to have a swap-based index which closely matched fund liabilities. As a result, Lehman decided to extend our swap indices to nominal zero-coupon and inflation swap indices to allow for exact cashflow matching, which we launched in the summer of 2006," says Phillips.
Various maturity buckets are represented by the Barclays Capital indices - such as five to 50-year benchmarks - and the bank also has separate benchmarks for non-inflation-linked liabilities, inflation-linked liabilities as well as swaps that provide exposure to inflation only, says Bektas.
In addition, the indices can be used as underlying building blocks in alpha-generating index strategies, which is a growth area for Barclays Capital's index business, according to Samad.
"They provide a measure of the mark-to-market return between two points in time on swap positions that pension funds may have in their portfolios," says Stephen Woodcock, principal at Mercer.
"Before liability swap indices were developed the closest index a pension fund could use to track the mark-to-market of its liabilities was the FTSE over 15-year index-linked bond index but it was not related to pension funds' liabilities," notes Robert Gardner, partner at advisory firm Redington Partners.
"Swap indices allow pension funds to model their liability cashflows using a portfolio of swaps and create a bespoke but transparent liability benchmark, which tracks the present value of their liability cashflows with respect to movements in interest rates and inflation. The bank providing the swap indices will upload this bespoke pension fund benchmark onto an Internet site or Bloomberg, which means that pension funds can track the performance of their liabilities on a daily basis, as interest rates and inflation change. They are a powerful tool allowing clients to create tailor-made benchmarks against which their asset managers can be benchmarked, resulting in better transparency and monitoring of the performance of their assets and liabilities. The bank will also quote swap contracts against the liability benchmark which allows the pension fund or asset manager to swap out the risk precisely." says Gardner.
Barclays Capital developed both nominal and inflation swap indices to provide solutions for different types of liabilities The swap indices are currently aimed at the pensions and insurance market in the UK, continental Europe and the US.
"We expect asset managers to utilise these indices as they look at their portfolios relative to mandates, as well as investment consultants and actuaries to help trustees design mandates," says Bektas.
Although Woodcock says the swap indices could be used by any type of pension scheme, he notes that the UK pension funds that have invested in swaps are to a large extent corporate private pension funds as the use of swap contracts by local authorities is restricted, which means they would have to make use of them indirectly via a vehicle, a structured note or a fund.
Woodcock also points out that the Barclays Capital swap indices are constant maturity swaps that are rebased on a monthly basis.
"This is not what most UK pension funds do," says Woodcock. "As most of them are closed schemes, they normally set up a swap portfolio whose maturity winds down over time. In that sense, the swap indices may not be as useful for benchmarking the performance of UK pension fund swap portfolios as they may be for other European pension funds, where constant maturity swap portfolios are more common."
One issue common to all swap indices, according to Woodcock, is that they only have one underlying pricing source.
In other words banks use their own pricing information to try to construct the indices. But there is scope for divergence between banks in terms of pricing of these contracts, especially for inflation swaps, he adds.
"As with all benchmarks, transparency and good quality pricing are key considerations. For the nominal-based indices returns are driven by changes in the swap curve with one bank's swap curve being very similar to that of another bank," says Phillips. "However, due to the nuances of the inflation swap market, care needs to be taken to ensure that the returns of inflation swap indices accurately reflect market levels and varying seasonal assumptions," says Phillips.
"Your therefore need to have as much transparency as possible around the construction of your indices and make sure that the break-even curves and seasonal factors are fully available to clients."
Woodcock says one of the primary reasons behind the launch of swap indices is banks looking to write product based on these indices in future and thereby turning it into a profitable exercise. "But if a certain index becomes a recognised market measure then other banks would tend to start writing contracts on it anyway," he says. "However, a market leader has yet to be established as far as swap indices are concerned."
"Most investment banks have been proposing for some time that pension funds model assets against liabilities and a number of those banks now offer swap indices. The question is which bank will emerge as the dominant swap index provider," says Gardner.
But Phillips says he is not worried about the competition. "We welcome competition because looking at LDI indices in this way offers alternatives over traditional approaches such as composite bond index benchmarks which seek to broadly reflect the duration of liabilities.
"We first saw interest in liability-driven indices a few years ago as a result of the reduction in the funding or solvency ratio. And at the moment Europe is the leader in terms of the use of liability benchmarks, in particular the UK and the Netherlands," says Ravin Onakan, responsible for marketing in Scandanavia and Holland at Lehman Brothers.
"While swap indices may be used to highlight the effect of interest rates and inflation on a pension fund's liabilities on a real time basis they are not a total solution. Longevity, and other demographic and fund-specific structural risks are not covered by these indices, notes Gardner, adding that the industry is working hard to devise a practical longevity hedge. In the meantime, he says, these can be mitigated by updating the swap indices on a regular basis as the cashflows and the longevity assumptions change.
"We first saw interest in liability driven indices a few years ago as a result of the reduction in the funding or solvency ratio," says Ravin Onakan, responsible for marketing in Scandinavia and Holland for Lehman Brothers. "And at the moment Europe is the leader in terms of the use of liability benchmarks, in particular the UK and the Netherlands."
"Currently, our clients would tend to use more bespoke measures, but time will tell whether any of these indices hold any specific advantage over this approach or indeed relative to each other," says Nick Horsfall, senior investment consultant at consultancy Watson Wyatt.
For providers the future looks promising, with Samad already noticing an uptake in interest in the consultants industry on both sides of the Atlantic since Barclays Capital made the set of tools publicly available.
"A lot of the asset liability management techniques that have been implemented in the UK are relatively underutilised in the US," says Bektas. "And due to this modest starting base, the interest around asset liability management and LDI should in our view grow faster in the US than in the UK and the rest of Europe."