Reducing Interest Rate Risk in Volatile Markets


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AEGON's senior account manager Gerben Borkent discusses how pension funds can protect themselves from interest rate risks in volatile markets.

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Reducing Interest Rate Risk in Volatile Markets

  1. 1. REDUCING INTEREST RATE RISK IN VOLATILE MARKETS Gerben Borkent, Senior Account Manager, TKP Investments Interest rate risk forms a significant risk for pension funds, as the value of pension liabilities increases as interest rates decrease. As a result, pension funds look to protect themselves against low interest rates.1 With reference to the Netherlands, this article discusses the available options and explains how to ensure that interest rate risk solutions provide the appropriate level of protection. Protecting against interest rate risk For pension funds the value of pension liabilities is strongly dependent upon interest rates. In the Netherlands, the Dutch pension law requires future pension liabilities to be discounted at the current market rates for interest rate swaps. A decline in interest rates therefore means that liabilities rise, causing a decline in the funding ratio of the pension fund. Pension funds can protect against this risk by linking the value of their investments to the current interest rate. There are several methods to match interest rate risks in pension fund liabilities: Cash flow matching Matching average bond duration by:  Changing the average duration of the existing portfolio  Adding long duration bonds to the portfolio to increase average duration (Strategic Allocation Fund; Long Duration Overlay)  Adding several ‘buckets’ of bonds to the portfolio to better match duration between several duration points in the portfolio Creating a customised risk overlay using interest-rate derivates. Depending on the size of the pension fund and the level of risk that trustees are willing to take, one solution is better suited than another. While medium to small pension funds often choose to increase their bond duration by matching the bond portfolio or adding longer duration bonds, larger pension funds with an experienced pension risk management department or a professional integral balance sheet manager often use risk overlay instruments. Cash flow matching is less common, as duration matching tends to be more flexible and cheaper to implement. One instrument that is often used by larger pension funds is an interest-rate swap, where a pension fund agrees with a counter party that it will receive an agreed rate of interest annually but will pay a variable rate in return.2 The value of1 Under IAS 19, the discount rate for pension liabilities is based upon high quality corporate bonds. Hedging on a local level will nottherefore necessarily provide full protection on a corporate level,See further One potential issue with interest rate swaps is that they offer protection in the case of declining interest rates. Pension funds needto be aware that protection is provided at the price of potential growth when interest rates increase. One way to manage this risk isto buy options on interest rate swaps instead (‘swaptions’) which can remove the downside risk of interest rate volatility but allow 1 May 2012
  2. 2. such interest rate swaps is heavily dependent upon interest rate levels and enables pension funds to cover the interest rate risk of their liabilities to the extent that they wish to do so. Interest rate protection in practice If we assume that the degree of interest rate risk that needs to be protected against has been properly calculated, there are two important reasons why fixed income investments and interest rate swaps may nevertheless fail to provide the desired level of protection: The change in the level of interest rates can differ for different maturities of bonds and interest rate swaps. Unlike the value of the liabilities, the value of the fixed income investments is not dependent upon the market swap rate alone. Duration-matching is vital In order to provide complete coverage of interest-rate risk, the maturities or duration of the portfolio of fixed-income securities and interest rate swaps must be precisely matched to the liabilities of the pension plan. If this is not the case, then the protection provided will not be complete whenever the yields of different maturities of fixed-income securities develop in a different way. The level of yield when shown against the appropriate maturity is called the yield curve. The risk of mismatching durations is called yield curve risk, as it is a result of a change in the shape of the yield curve. Yield curve risk There can be good reasons for not completely protecting against yield curve risk. For example, when the long-term yield is lower than the short-term yield (an inverse curve) or if it is expected that the curve may rise again in the future (in which case swaptions may be a better option). If there is an inverse curve, complete protection against yield curve risk results in a lower return on investments than if protection is based on an on average shorter duration. This assumes that the form of the yield curve remains the same or that longer term yield rises compared to shorter term yields. Bond prices and risk Investors demand a higher yield on fixed income investments with a higher risk profile. This means that the market value of a bond depends on the market’s judgment of how likely it is that the loan will ultimately be repaid. The changes in market value of some fixed income investments on this basis can be considerably larger than the shifts caused by changing interest rates. This more volatile class of fixed income investments include bonds issued by businesses with weak balances (high yield bonds) or issued by governments of developing countries (emerging market debt). These investments are therefore unsuitable for protecting against the interest rate risk of the liabilities of pension funds. Inflation-linked government bonds are also not always suitable for protecting completely against nominal interest rate risk.funds to benefit from the potential upside. See also 2 May 2012
  3. 3. Risk-free investments?Until the present debt crisis, euro-denominated government bonds were generally considered to be‘risk-free’ investments. The valuations of euro government bonds therefore almost only changedwhen interest rates changed. Thus, until recently, the yield on interest rate swaps and governmentbonds from, for example, Germany and Italy, was largely identical. This has now changed, as theyield on Greek, Irish, Portuguese, Spanish and Italian government bonds has increased rapidly. As aresult, the actual return on these bonds has been significantly less than would have been expectedon the basis of the changes in the swap rate, as illustrated below.Figure: Difference between intended and actual interest rate protection – changes in the extra yieldof euro bonds above the market swap rate (source: TKP Investments).With such dramatic changes in yield (and implicit risk), the actual interest rate protection can differconsiderably from the level of protection that was originally intended. For example, if the swap ratefalls, the value of liabilities rises. However, if, at the same time, the difference in yield betweengovernment bonds and the swap rate rises, the value of the investments will only rise slightly or evenfall.Protecting against changes in the value of fixed income investmentsIt is not easy for a pension fund to protect itself completely against the changes in the value of fixedincome investments. If there is a positive difference in yield between government bonds and theswap rate, in the beginning this may lead to a higher return on investment than one based on theswap rate alone. Although money markets may provide some protection for pension funds in theory,in practice such a move it unlikely to be attractive. Pension funds can invest in money markets, anduse interest rate swaps to protect against interest rate risk. Unfortunately, pension funds, unlikeindividuals, have no access to a guaranteed deposit. As a result, all funds that are kept as cash areliable to counter party risk. In part, such counterparty risk can be covered by asking for collateral(which itself consists of government bonds). However, the return on cash is typically considerably 3 May 2012
  4. 4. lower than the variable interest that the pension fund has to pay on the interest rate swaps, and, as aresult, the pension fund is likely to make a loss.Another alternative for providing protection is to invest in short-maturity government bonds of safercountries, such as Germany or the Netherlands. However, the yield on the very short maturitygovernment bonds of these countries has recently been very low or even negative.No protection is perfect – be alert to remaining risksWhen looking to protect themselves against interest rate risk, pension funds must remain alert to therisks described above. It is important to be aware of the actual degree to which the fund is protectedagainst changing interest rates and under what circumstances the protection may prove to bedifferent from what was originally intended. Pension funds can then make carefully argumentedcorrections to their risk management policy, for example, by not including high yield and emergingmarket debt when protecting against interest rate rises or by altering the degree to which interestrate risk is held to be relevant for more risky fixed income investments.About TKP investmentsAEGON company TKP Investments is an investment company specializing in integrated risk andbalance sheet management and multi management for pension funds and insurance companies. It isan independent operating business unit within AEGON Asset Management and manages more than€15 billion in assets of over 30 large pension funds.An integral approach to assets and liabilities allows TKP Investments to offer Dutch pension funds afull asset management and risk control advisory service. A dedicated and highly qualified team ofinvestment strategists is responsible for providing strategic advice to its clients. The team performsextensive Asset Liabilities Management studies and gives advice on various strategic and riskmanagement issues. This includes managing the duration mismatch between assets and liabilities.TKP Investments is the manager of the multi-manager funds of AEGON’s asset pooling solution. Itwas the winner of the Multi-Manager of the Year Award in 2008, 2009, 2010 and 2011 andFiduciary Management Firm of the Year in 2010 (European Pensions). TKP Investments is ISAE3402 certified.For more information, please contact Gerben Borkent, Senior Account Manager at TKPInvestments: Tel. +31 50 317 5 392 4 May 2012