Innovation fills the asset/liability gap
The search for yield has been producing great innovation in credit for some time. Now the focus has moved on to the more complex problems of European pension funds. Closing the yawning gaps between pension fund assets and liabilities takes more than a bit of yield enhancement to fix. Complex derivatives structures are often involved.
To funds that have traditionally shied away from derivatives on grounds of risk and complexity, these structures can seem a little outlandish. As a result many have refrained from using them.
But as things stand, pension fund managers are faced with considerable duration imbalances in their balance sheets (the impact of changing interest rates on a portfolio of bonds) as well as facing other risks such as changes in life expectancy, retirement dates etc.
Enter innovation. While swap overlays have been used to counter duration gaps, houses such as SG CIB are now promoting duration bonds as a way of achieving the same goal without entering a derivatives contract. Duration bonds on the asset side can achieve this.
“At SG CIB we have found that this kind of bond, combining both the customised aspect of a swap overlay and the simplicity of a bond, has generated significant interest from pension funds,” says a senior banker at SG CIB.
The other critical problem for pension funds is hedging against inflation. Here the problem is lack of supply of inflation-linked bonds. Despite the publicity they have received, the inflation-linked bond remains small. Index-linked gilt issuance amounts to about £3bn a year which could all be absorbed by a single fund. The solution here does have to involve derivatives.
The aim is to enhance yield on the asset side that will outstrip inflation. Products that use the correlation between interest rates and inflation are being designed as are inflation-linked CDOs. The much heralded arrival of the 50-year bond, being discussed by both French and British governments, would be another useful tool for matching long-term cash flows. Agence France Trésor indicated that it would issue a 50-year euro OAT 2055 as The Banker went to press.
Then again, if a pension fund is too heavily invested in equities there are tools using caps and floors to turn this into fixed-income like cash flows. If you thought pensions were dull, think again.
