Implementation of interest rate hedging under the Wtp
This article was originally written in Dutch. This is an English translation.
By Niek Swagers and Yiyi Huang
Interest rate hedging remains important, even with the introduction of the Wtp. Which investment instruments are suitable for this and how does the negative swap spread influence the implementation of interest rate hedging?
Hedging interest rate risk has always played a crucial role in the investment policy of pension funds to protect the funding ratio against interest rate movements. Interest rate hedging remains an important component under the Wtp, as the final level of the pension benefit depends on the interest rate. Interest rate swaps will remain essential for implementing interest rate hedging in this new system.
The main advantages of interest rate swaps are:
- A high degree of liquidity, especially for long maturities.
- A minimal basis risk in relation to the valuation curve for the expected cash flows (pension payments).
- A limited investment requirement due to the derivative nature of interest rate swaps. This leaves a relatively large amount of money available for investment in the return portfolio.
However, as under the FTK, there is also room for other instruments. These include government bonds, high-quality corporate bonds and Dutch mortgages. For example, government bonds with a high credit rating (such as Dutch or German) can act as collateral for interest rate swaps. They also offer a safe haven for investors in a crisis situation and the return can be attractive compared to interest rate swaps (in the event of a negative swap spread – more about this later). Corporate bonds and mortgages can also contribute by generating extra returns in combination with more diversification.
The choice of certain instruments does, of course, depend on the type of pension contract. Table 1 provides an overview of the application of interest rate hedging instruments and their role within the chosen contract form under the Wtp.
In the context of the Wtp, we therefore see considerable variations in the organisation of the interest rate hedge, depending on the type of contract that a pension fund chooses. For example, in the SPR-T contract, interest rate swaps and government bonds are mainly chosen in the protection portfolio in order to keep the deviation from the swap interest rate as small as possible. After all, this swap interest rate determines the allocation of the theoretical protection yield. Other fixed-interest investments, such as corporate bonds or mortgages, end up in the return portfolio to ensure extra yield and optimal diversification within the total investment policy for participants.
For the SPR-W and FPR contracts, the allocated protective return is directly linked to the actual return achieved in the protective portfolio. That is why, in addition to interest rate swaps, corporate bonds, mortgages and inflation-related instruments (such as ILBs or inflation swaps) can also be used directly in the anti-takeover portfolio. This offers pension funds more flexibility in their investment strategy, for example if a real ambition has been explicitly formulated.
Interest rate swaps versus government bonds
Interest rate swaps and government bonds therefore remain the most important instruments for interest rate hedging under the WTP. The choice between the two is partly determined by the swap spread, i.e. the interest rate difference between the swap rate and the interest rate for government bonds with the same maturity. However, it is important to emphasise that this is by no means the only consideration. For example, a higher allocation to government bonds will increase the basis risk and mean that less money is left for the return portfolio (due to the smaller leverage than with interest rate swaps).
Until 2024, the swap spread was positive, which meant that interest rate swaps offered a higher interest rate than government bonds. However, since the second half of 2022, the swap spread has fallen and even turned negative. Various factors influence the development of the swap spread, such as the increasing demand for interest rate hedging by Dutch pension funds in the run-up to the transition to the Wtp, the ECB's monetary policy measures and the weak economic situation in Germany.
With the current negative swap spread, it may seem advantageous for pension funds to opt for government bonds instead of interest rate swaps, especially with regard to interest rate hedging over longer terms. This is because long-term government bonds currently offer a higher interest rate than interest rate swaps.
Opting for government bonds does mean that less money is available for the return portfolio, as interest rate swaps can be used more efficiently thanks to their leverage effect. On the other hand, AAA government bonds have traditionally been a safe haven and can therefore offer extra protection in times of major shocks on the financial markets.
From a risk management perspective, we believe a combination of both instruments is desirable. This allows the pension fund to benefit from the major advantages of both instruments: the extra protection of government bonds and the extra leverage of interest rate swaps.
In summary, various factors are important for pension funds when choosing between interest rate swaps and government bonds:
- Basis risk: The expected cash flows are valued (and allocated under SPR-T) with the swap interest rate and not with the government bond interest rate. Although the interest rate on German government bonds is currently close to the swap interest rate, the swap spread may vary in the future, which brings uncertainties.
- Use of leverage: Interest rate swaps offer pension funds the opportunity to realise a high interest rate hedge with a relatively small amount of capital. This is very important for pension funds that want to maintain sufficient allocation to a return portfolio.
- Limited supply for long maturities: Countries with an AAA rating, such as the Netherlands and Germany, often do not issue bonds with maturities longer than 30 years. Despite the more limited need for interest rate hedging on long maturities under the Wtp, this limited supply can influence the choice of pension funds.
Combination of interest rate swaps and government bonds
In the context of the Wtp, we see variations in the organisation of the interest rate hedge, depending on the type of contract a pension fund chooses. The application of different investment instruments in the protection portfolio or the return portfolio plays a key role in this. We expect interest rate swaps and government bonds to remain important in hedging interest rate risk. Although long-term government bonds may currently appear more attractive than interest rate swaps due to the negative swap spread, the combination of interest rate swaps and government bonds ultimately offers better protection and better diversification, while leaving sufficient room for achieving excess returns.
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Niek Swagers Head of Investment Solutions, Aegon Asset Management |
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Yiyi Huang Senior Investment Solutions Consultant, Aegon Asset Management |
