| Interest rate hedging pays off for Denmark's largest institutional investor |
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| 25/09/2005 | |
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Interest rate hedging can also be used to spice up returns. ATP, the Danish labour market supplementary pension scheme, is here to prove it. Denmark's largest institutional investor doubled its investment returns in the first half of 2005 thanks to a €3.48bn return on its interest rate hedging instruments. ATP's total market return on investments was €5.9bn before tax, equivalent to a rate of return of 14.5% over the period. While ATP highlighted that all its asset classes had a significant impact of its returns, interest rate hedging instruments, swaps for the most part, were the single most important contributors to the scheme investment returns. ATP's good hedging instrument performance was mostly due to their combination with high bond returns due to falling interest rate. As swaps have become both cheaper and easier to trade, interest rate hedging programmes have become increasingly popular among pension schemes looking for every single return opportunity. However, supplementary returns, in the words of Merrill Lynch's analysts, are only an "ancillary benefit" of implementing swaps. For ATP, which has 71% of its portfolio invested in fixed income, incremental return is not the first objective. The scheme rather seeks to hedge the market risk associated with guaranteed benefits by increasing the average duration of its bond holdings in order to get a better cash-flow matching capacity. Earlier in the year, the defined benefit pension fund of UK chemist Boots announced that it would use interest rate and inflation-linked swaps for this very reason. Risk For schemes heavily invested in fixed income such as ATP or Boots, this has become all the more necessary with bond holdings that now include corporate bonds (including global credit and high yield bonds) that have a duration much shorter than the traditionally held long maturity sovereign bonds, which provide a closer fit to a scheme's liabilities as well as a superior long-term net plan performance. A scheme that does not implement interest rate swaps is exposed to what Merrill Lynch calls a "tremendous interest rate risk". According to Merrill Lynch's calculations, a 100 bps decline in interest rates would translate into an average increase in plan liabilities of 12%-15% and asset appreciation of only 1.5% in the current interest rate environment. "A fully funded plan a the beginning of the year that does not hedge interest rates is four times more likely to be under funded at the end of the year than a plan that does", say Merrill Lynch analysts. However, interest rate hedging also has a downside. For instance, a pension fund that has entered an interest rate swap agreement might be protected against a fall in the interest rate, but will also miss out on a rise. Also, many pension funds are simply uncomfortable with those instruments given the level of sophistication of those derivatives. Some fund managers have stepped in to fill the gap and, now offer pension funds lacking the resources liability driven pooled funds that include swaps. J.L. |
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