Pension funds should start considering the impact of an interest rate rise and instruct their asset managers to make adjustments, according to Aegon Asset Management.
Without changes, interest rate increases would cause considerable damage to schemes’ portfolios of euro-denominated government bonds, warned Hendrik Tuch, head of interest and money markets at Aegon AM.
Speaking at the annual congress of IPE’s Dutch sister publication PensioenPro in Amsterdam last week, he said rates were likely to rise as a consequence of the European Central Bank (ECB) reducing its quantitative easing policy.
According to Tuch, Aegon AM expected that the ECB would signal its intentions after the summer. Government bond yields would rise later this year as a result.
He said interest rates were unlikely to increase to the level of past decades, but could climb to 1.5% or 2%. The main interest rate for the euro-zone has been 0% since March 2016.
Tuch said almost 80% of German government bonds and more than 60% of Dutch government bonds traded against a negative rate. He added that he didn’t expect a profit could be made on government paper during “the coming years”, and argued that Germany’s low interest rate was “simply unsustainable”.
The average duration of government bonds was increasing, Tuch added, with some governments issuing paper with an extremely long duration – sometimes 100 years.
“Most pension funds will be exposed to this development through their index portfolio,” he added.
According to Tuch, interest rates on credit and high yield bonds were also at historic lows, with owners also not prepared for a rate increase.
In his opinion, pension funds should consider replacing their liquid bonds with illiquid fixed income investments.
“These aren’t bought by the ECB, have a lower bubble potential, and deliver extra returns,” he argued.
Tuch cited residential mortgages as an alternative, “as they produce considerably better returns than Dutch government bonds against an acceptable risk-return ratio”.
Illiquid corporate loans as well as loans with a government guarantee would also be an alternative to government bonds, he said.
Aegon was anticipating the ECB’s policy by going short on Italian interest-rate derivatives and regularly taking profits, Tuch said.
Aegon had also cautiously switched to an underweight duration for government bonds, relative to the benchmark. He recommended pension funds follow this example and cash in when interest rates rise.
Tuch also suggested that pension funds revise their interest rate hedges, arguing that central clearing of derivatives – as required by EMIR regulations – had “important advantages” relative to bilateral swaps. He said that Aegon AM had already fully switched to central clearing. However, he didn’t elaborate on the advantages.
The last time the ECB raised its main interest rate was in 2011, when the rate increased by 25 basis points in April and July, reaching 1.5%. However, it was forced to reverse this move by the end of the year as several euro-zone economies struggled to pay off debt.