Derivatives 2006 - Calling ALM
End-user activity in the interest rate derivatives market connected to asset and liability management (ALM) has become a core focus for market speculation. Anticipation of hedging activity now routinely moves markets and creates trading opportunities for sophisticated investors like hedge funds. Mark Pelham reports.
ALM trades from insurers have been around for a long time. As early as the mid-1990s, UK insurance companies were regularly seen in the swap and swaption markets attempting to hedge guaranteed annuity options.
Other countries’ insurers have followed suit, all with the problem that similar guarantees on insurance contracts make them effectively short volatility and short duration. The hedging of defined benefit pension schemes has captured the market’s interest in recent years, however.
Legislation has been upgraded in countries where these type of schemes proliferate – the UK, the US and Denmark, the Netherlands and Sweden – meaning that their asset and liabilities have to be more closely measured and matched. Consequently, the necessary hedging activity at the long-end of the curve – given the huge needs of these schemes and the paucity of cash instruments in longer tenors – has led many to expect high levels of derivatives use.
There has been some confusion about how much actual derivatives use there has been. For example, in July two surveys appeared in the UK suggesting very different answers.
In its annual survey of FTSE 350 pension schemes, Mercer Human Resource Consulting found that only 6% of UK schemes used interest rate derivatives and just 4% utilised inflation-linked instruments. But the same week Watson Wyatt, another pensions consulting firm, reported that derivatives use among pension funds was surging. It said the volume of inflation-linked derivative deals among pension funds had trebled from £3bn to £9bn between 2004 and 2005, and was set to more than double to exceed £20bn this year.
The confusion over inflation-linked derivatives is easily explained: many funds do not invest in them directly.
Rashid Zuberi, head of Deutsche Bank’s insurance and pensions group in London, said: “In terms of inflation, LDI [liability driven investment] has become a buzz word when it comes to UK pension funds, which are still going to managers who provide LDI funds because it is easier to explain to the trustees that you are buying units in a fund than buying a zero coupon inflation swap. The LDI underlying is a derivative, so whether they are doing it direct or not, pension funds are using derivatives to hedge their liabilities.”
But the non-use of interest rate derivatives is less readily explainable – although the timing of trades could lead to an inconsistency in survey results.
Meyrick Chapman, head of derivatives strategy at UBS, said: “In the case of the UK there is lots of stuff going on, but it is intermittent – it tends to be chunky deals that are followed by nothing for sometimes weeks. The UK is all about ongoing pressure, but there are a number of trigger points that generate trades.”
One such trigger point came earlier this year as companies had to make returns to the Pension Protection Fund detailing their outstanding assets and liabilities. “A lot of firms were quite keen to rule off their liabilities at that point,” said Chapman.
“Another trigger revolves around mergers, which, like elsewhere in the world, the UK has seen a great deal of this year. It can often be that a merger is held up because of an unsafe pension fund and one of the ways to get the merger moving again quickly is to hedge the pension fund’s liability,” he added.
The next country after the UK to enter the derivatives market in size was Denmark, with its new pension rules being established in 2001. The activity of Danish funds in the euro-denominated markets was the first to really capture dealers’ imaginations and today, while Danish activity is less than in its early days, funds are still seen in the market on a regular basis either re-hedging or improving trades. Many adopted similar strategies to those seen in the sterling market – buying receiver swaptions or receiving fixed and buying out-of-the-money payer swaptions.
Danish funds are not only exposed to rates going down. Zuberi said: “They are also exposed to rates going up because it is far easier for individuals to cash in their policies. But Danish asset managers and actuaries are able to cope with this by using derivatives. A lot of their assets are Danish mortgage bonds, so they know what convexity positions are and have been hedging them using options – they are very derivatives savvy.”
Netherlands-based schemes appear to have been even more savvy, thanks to learning from the Danish experience. Some excitement over potentially large volumes of trading was caused among the less well-informed in the market when the new Dutch pension law was signed in parliament towards the end of September.
But most of the significant groundwork is understood to already have been laid in the past two years. It is expected that Dutch activity will continue, however.
Evidence that the Dutch have been involved in significant hedging activity is that the official pension returns to the regulator as at the end of the second quarter showed overall solvency was 140%, the highest it has been in decades. The ratio was helped by the rise at that time of long-term rates, together with robust returns from equity investments.
Since then, Chapman observed: “Rates have fallen a lot and a number of Dutch funds have been hedging all the way up. Some companies did some significant hedging around 4.5% in the 30-year and continued as rates fell after June.”
Sweden’s pension regulations were amended in April, which generated a significant amount of derivatives use in the country. This is a result of both the market’s infancy and its complexity, according to Zuberi.
He observed: “Swedish pension funds have the same problems as elsewhere, but their problems are compounded. Where Danes could look at euro-denominated instruments because their currency is very closely correlated to the euro, Swedes do not have that luxury. So they typically look to put on trades in Swedish kroner initially, which can have liquidity issues, and maybe add a few euro hedges. However, the regulator has cautioned that extensive use of non-domestic currency instruments could give rise to the need to reserve capital against them. That said, the regulator has stated it will review the position going forward.”
The Swedish experience apart, the general rule so far has been that instruments used for ALM should be single-currency and as simple as possible. This is partly due to the need to explain products to trustees and also the requirement for liquidity often set by risk committees – with deal sizes running into multiple billions, structured products rarely offer a solution.
Instruments therefore tend to be vanilla rate or inflation swaps, swaptions, CMS floors and CMS caps. Yet, as ALM becomes more widely understood by the end-users, there are signs of increasing inventiveness among dealers.
“There have been a whole variety of solutions in the derivatives space going on,” Chapman said. “One interesting one – which is currently getting a lot of airplay both here and in the US – is zero or low cost collars, whereby the fund sells a payer swaption that is 100 out from the one-, two- or three-year forward on the 30-year and with that premium buys a receiver 100 out on the downside. It is ideal for them because if rates go up they get exercised on the swaption and receive at a higher rate – and as rates go up, it means their liability stream goes down in value as well. On the other hand, if yields go down they are long the receiver so increasingly get exposure to protection.”
Such trades have proved so popular in Europe that they created market-wide difficulties. Chapman explained: “They put so much on they actually flipped the skew, which used to favour the payers over the receivers. Hedge funds spotted this and, arguing that such a situation was uneconomic, put on heavy positions going the other way.”
Then rates went up and the pension funds got hit by mark-to-market losses. “A few bought back payers at a loss in some cases, but some put on lots more collars and as rates have come down they have actually been taking off the payers for decent profits. So, what that leaves them with is a sort of semi-subsidised open long receiver swaption position and, consequently, the skew has moved back the other way,” Chapman said.
It looks likely that awareness of the use of derivatives will grow among pension funds and insurers across Europe – and, consequently, trade volumes in connection with ALM will also continue to increase. As Zuberi said: “It is fair to say when we go and pitch to anyone they all want to know is what is happening with their neighbours and what they are doing, whether regulations have come into their country or not. For example, when we started focusing on Germany a couple of years ago, firms there said: ‘We don’t have to do anything, but it would be nice to know what others are doing, just in case’. So when it came to them doing something last year, they were very well prepared because they knew exactly what was going on in the rest of Europe.”