1 May 2012

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 of

1 Under IAS 19, the discount rate for pension liabilities is based upon high quality corporate bonds. Hedging on a local level will not

therefore necessarily provide full protection on a corporate level, See further http://www.aegonglobalpensions.com/Documents/aegon-global-pensions-com/Publications/Newsletter-archive/2011-Q3/Impact%20of%20IAS19%20on%20corporate%20pensions.pdf. 2One potential issue with interest rate swaps is that they offer protection in the case of declining interest rates. Pension funds need

to be aware that protection is provided at the price of potential growth when interest rates increase. One way to manage this risk is

to buy options on interest rate swaps instead (‘swaptions’) which can remove the downside risk of interest rate volatility but allow

2 May 2012

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 http://www.aegonglobalpensions.com/en/Home/Publications/News-

archive/News/Protecting-TNTs-pensions--the-benefits-of-swaptions-/

3 May 2012

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 changed

when interest rates changed. Thus, until recently, the yield on interest rate swaps and government

bonds from, for example, Germany and Italy, was largely identical. This has now changed, as the

yield on Greek, Irish, Portuguese, Spanish and Italian government bonds has increased rapidly. As a

result, the actual return on these bonds has been significantly less than would have been expected

on 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 yield

of 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 differ

considerably from the level of protection that was originally intended. For example, if the swap rate

falls, the value of liabilities rises. However, if, at the same time, the difference in yield between

government bonds and the swap rate rises, the value of the investments will only rise slightly or even

fall.

Protecting against changes in the value of fixed income investments

It is not easy for a pension fund to protect itself completely against the changes in the value of fixed

income investments. If there is a positive difference in yield between government bonds and the

swap rate, in the beginning this may lead to a higher return on investment than one based on the

swap 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, and

use interest rate swaps to protect against interest rate risk. Unfortunately, pension funds, unlike

individuals, have no access to a guaranteed deposit. As a result, all funds that are kept as cash are

liable 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

4 May 2012

lower than the variable interest that the pension fund has to pay on the interest rate swaps, and, as a

result, the pension fund is likely to make a loss.

Another alternative for providing protection is to invest in short-maturity government bonds of safer

countries, such as Germany or the Netherlands. However, the yield on the very short maturity

government bonds of these countries has recently been very low or even negative.

No protection is perfect – be alert to remaining risks

When looking to protect themselves against interest rate risk, pension funds must remain alert to the

risks described above. It is important to be aware of the actual degree to which the fund is protected

against changing interest rates and under what circumstances the protection may prove to be

different from what was originally intended. Pension funds can then make carefully argumented

corrections to their risk management policy, for example, by not including high yield and emerging

market debt when protecting against interest rate rises or by altering the degree to which interest

rate risk is held to be relevant for more risky fixed income investments.

About TKP investments

AEGON company TKP Investments is an investment company specializing in integrated risk and

balance sheet management and multi management for pension funds and insurance companies. It is

an 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 a

full asset management and risk control advisory service. A dedicated and highly qualified team of

investment strategists is responsible for providing strategic advice to its clients. The team performs

extensive Asset Liabilities Management studies and gives advice on various strategic and risk

management 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. It

was the winner of the Multi-Manager of the Year Award in 2008, 2009, 2010 and 2011 and

Fiduciary Management Firm of the Year in 2010 (European Pensions). TKP Investments is ISAE

3402 certified.

For more information, please contact Gerben Borkent, Senior Account Manager at TKP

Investments: gerben.borkent@tkpinvestments.com Tel. +31 50 317 5 392