By David Hickey
The pledge by Bank of England (BoE) Governor Mark Carney to keep the base rate at a record low 0.5% for at least the next three years appears to offer little respite for deficit burdened defined benefit (DB) pension schemes. So what does the future hold for interest rates and, more importantly, how can pension schemes position themselves for any changes?
The investment markets imply that interest rates will rise ahead of BoE expectations. 90-day sterling futures contracts price in a 25bps* hike by 2014 and the gilt curve predicts the three month gilt yield will rise by around 2%* over three years.
Such pricing reflects recent promising economic data e.g. the strong September PMI (Purchasing Managers Index) numbers, the prospect of Fed tapering (the US Federal Reserve winding down its asset purchases) and signs of stabilisation in the eurozone.
If economic conditions continue to improve, unemployment may hit 7% earlier than 2016 (the threshold at which the BoE would consider a rate rise) and it is possible that rates could rise in advance of current market expectations once again (as they did between May and September this year when 10-year gilt yields rose by around 1%).
An interest rate rise ahead of market expectations will typically generate a positive outcome for DB schemes in the form of higher funding levels. Schemes who share the view that a rate rise is likely to occur ahead of BoE and market expectations may wish to consider taking steps to exploit this opportunity. To this end, there are various options available:
Holding fewer matching assets?
A scheme can hold fewer matching assets, such as bonds, such that if rates rise and scheme liability valuations consequently fall, they will not be as negatively impacted by the resulting decline in their gilt and bond values.
Reduce the interest rate sensitivity of matching assets?
A scheme can maintain its current matching asset allocation but reduce its interest rate sensitivity by buying shorter dated bonds (generally only advisable if yield efficient) or by using shorter-dated or fewer derivatives (if derivatives are currently being used).
Use options?
Schemes already using derivatives may wish to consider morphing an element of the derivative portfolio into a directional view on rates using options, while broadly maintaining physical allocations. While most derivative techniques such as swaps (or synthetic gilts or gilt repo contracts) aspire to fully remove interest rate risk, by using options, for a period of perhaps six months to five years, a scheme can elect to take exposure to a long-dated interest rate such as the 20-year swap rate within a range e.g. between 3.5% and 4.5%. This offers a blend of partial participation in a rising rate market at the same time as maintaining protection should rates fall.
A sound approach The most sensible approach is likely to be one that draws on elements of all three options detailed above. This may take the form of a moderately reduced overall hedge achieved via holding fewer matching assets while maintaining an optimal amount of derivative leverage (only using shorter duration bonds if yield efficient), with a proportion of hedging undertaken via options.
The key is to implement these strategies in every investor’s case so they are customised to their needs, based on trustee risk appetites, their understanding and willingness to use derivatives and unique delegation preferences.
* Source: Bloomberg Finance L.P. as at 10 October 2013
David Hickey is director, SEI Institutional Advice, EMEA
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