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How should pension funds deal with the risk of rising interest rates on the capital markets? Is it sensible to hedge interest rates or should we focus more on inflation risks? Three experts highlight the interest rate related issues for pension funds in the light of the new Financial Assessment Framework.
In the last year, pension funds have been faced with an ongoing decline in interest rates. There have been cyclical and temporary reasons for this, such as the weak economic growth in Europe and the low oil price. In conjunction with this, inflation expectations have fallen too and there has been increasing speculation that the ECB will apply quantitative easing. The ongoing easy monetary policy in the US and the considerable appetite of Japanese pension funds for European government bonds have caused downward pressure on yields in the Eurozone.
But structural factors have also played a role in the interest rate decline, explains Lukas Daalder, CIO of Investment Solutions. “Aging populations in Western industrialized countries have an increasing preference for 'safe' government bonds, while the supply in the market is actually decreasing as a result of shrinking government deficits and central bank buyback programs," says Daalder. The savings surplus is many countries is also keeping interest rates low: “There is an unprecedentedly large pool of savings worldwide and some of this money is finding its way into the European capital market."
Daalder expects the downward trend to come to an end this year: “The fact that real interest rates are negative along the entire length of the German yield curve strengthens the feeling that the market is too gloomy and that there should be a change in direction from these very low levels. However, I expect this to be a moderate turnaround. It is true that bonds are overvalued, but given the fact that the ECB is stimulating this over valuation and does not seem to have any intention of taking action in the short term, the upward momentum is not very likely to come from Europe." Daalder feels that upward pressure on rates is more likely to come from the US, where the Fed will hike interest rates in the course of 2015.
But he does not think the rate hike is a foregone conclusion, referring to the recently published Robeco report 'Expected Returns 2015-2019': "In our main scenario (60% likelihood) we assume a gradual rise in capital market rates to 3% in 2019. However, the fact that we allocate a 30% likelihood to a scenario of ongoing stagnation (a Japan scenario) demonstrates that there is a probability imbalance in this base scenario. Certainly in the case of Europe, we cannot rule out the possibility that we may be entering a prolonged period of disappointing growth and slight deflation.
Jaap Hoek, portfolio strategist in the Investment Solutions Department, thinks that now is a good time for pension funds to take advantage of the risks relating to rising interest rates. “The new Financial Assessment Framework means that politicians are giving pension funds a one-off chance to adjust their strategic investment policy and the related risks. If our central scenario becomes reality, 10-year yields will rise to around 3% in the next five years. This rise will be accompanied by lower bond returns."
There will be many negative price moves, offset to some extent by positive, gradually increasing coupon returns in the next five years. Depending on how quickly interest rates rise, there will be years of positive returns and years of negative returns. Hoek: “On balance this will result in annualized total returns of 0.3%. So is it really worthwhile investing in bonds?"
According to Hoek, politicians have their doubts about this and they get support from pension experts. Jan Tamerus, actuary at asset management company PGGM, points out the dangers of rising interest rates, both alone and in combination with rising inflation. Because legislative and regulatory authorities force pension funds to hedge their interest rate risk at extremely low interest rate levels, the funds only have limited opportunities to benefit from any sudden increase in interest rates.
Hoek: “The funds could take action now, but would this be sensible? If we combine the returns in our interest rate scenarios with the probability levels we apply to them, this results in an expected year-on-year return of 70 basis points. However, interest rates have plummeted since we drew up these prognoses in July and the return potential has evaporated to an expected annualized return of 0%!
'The funds can now take action, but will they do so in a sensible way?'
The question as to why funds still carry out interest rate hedging seems a legitimate one. However, Hoek points out the relationship between hedging and liabilities. It is precisely at times when things are bad that hedging offers the necessary protection. Moreover, it is unclear how much a fund can benefit by opening its interest rate exposure. “The risk inceases relative to the liabilities, which means that risk may have to be reduced in other parts of the portfolio. The question then is what you give up and whether you want to do this."
In addition to the risk of rising interest rates, Hoek says it is also important to be prepared for rising inflation. “Rising inflation is a major risk because it erodes purchasing power. Inflation expectations look reasonably normal. Inflation swaps indicate that the market expects inflation to be above the 2% level in a few years. Expectations for nominal interest rates are also around this level, which implies an outlook for real interest rates of around 0%. The question now is whether, by reducing its interest rate hedge, a fund positions itself to benefit from the risk of rising inflation or the opportunities that rising real interest rates offer. The latter incorporates little or no risk for the fund.
According to Hoek, whether or not a fund decides to position itself to take advantage of this opportunity depends largely on its outlook. “In the light of our current outlook, we see opportunities, but the main challenge is how we should reallocate risk. We are still positive about most risk premiums, which means reallocation is still expensive at this point. This can of course change – certainly now that the funds have been given the opportunity to overhaul their strategic policy. Although many funds have limited or no opportunities to position themselves according to their interest rate outlook, these can now be created by, for example, incorporating a dynamic interest rate policy, or a policy with more flexible limits when it comes to interest rate hedging. This does not mean that the hedging policy has to be adjusted immediately, but that this is a viable option.
Remmert Koekkoek, senior portfolio manager overlay management, looks at the changes in the coverage ratio in different interest rate scenarios. In doing so, he assesses what the downside risk of reducing the interest rate hedge is. According to Koekoek, to do this you should not focus on the level of 1%, where the 10-year yield currently is. “In addition to the risk that rates could fall further, the downside is primarily linked to the fact that the market has already priced in a hefty interest rate rise. The market expects the 10-year yield to rise by a full percentage point in the next five years. The downside risk over this period should therefore be evaluated against an interest rate of 2%." At pension fund level, according to Koekkoek, this means that the coverage ratio will fall by an average of 10% over a five-year period, if interest rates stay the same over this period and the pension fund does not hedge its interest rate risk. So the interest rate hedge will in fact offer solid returns for the next five years if interest rates stay the same and even make a positive contribution if rates rise slightly. This shows that an interest rate hedge is worthwhile, even if you expect interest rates to rise slightly, says Koekoek.
'The downside lies mainly in the fact that the market has already priced in a hefty rate rise'
Can the interest rate hedge cause problems under the new system? According to Koekkoek a lack of interest rate hedge could actually be more of a problem in nominal terms. “In a real context, the question is to what extent indexation ambitions are compatible with a high level of interest rate hedging. The risk of a rate rise on the real coverage ratio becomes an issue primarily when the interest rate rise is driven purely by inflation. The current 20-year inflation rate in Europe is however 1.8% while nominal interest rates are at 1.6%. If 20-year yields rise significantly – for example, by 3 percentage points to 4.6% – the question is how fast will 20-year inflation rise? It is unlikely that it will rise in tandem and end up at a level of 4.8%."
The table shows the nominal coverage ratio impact of interest rate changes on a pension fund that hedges half of its interest rate risk. The scenarios in the table show that if interest rates rise by 3%, the annual nominal coverage ratio return will still be 4.2% per year. An interest rate hedge of 50% leaves plenty of scope to absorb an unexpected rise in inflation. Koekkoek's conclusion is clear: “The shift towards reducing the interest rate hedge is certainly not a decision that can be taken lightly, even in the light of current interest rate levels. This choice must be made carefully and a range of factors should be taken into account, such as the current level of interest rate hedging, the risk budget and the pension fund's market outlook.