Dutch pension fund PGB's corona-fuelled hedging challenge
PGB Pensioenfonds, the multi-industry EUR30bn Dutch pension fund for the graphic art sector, runs a liability matching and return portfolio (split 45/55 respectively) as well as a dynamic interest-rate hedging strategy. All three components move in line with the scheme's funding ratio, last marked at 101% at the end of February, before the coronavirus really hit markets. Since then, extreme volatility and illiquidity has left PGB drawing on every tool in its hedging kit, explains senior portfolio manager Roy Kroon in an interview Total Derivatives
PGB’s matching portfolio uses bonds, swaps and futures to hedge the interest rate risk of its liabilities, in a wholly euro denominated allocation free from any FX positions. Moreover, the matching portfolio is integrated into one mandate comprising all the instruments PGB needs to hedge interest rate risk, so there is no separate swap overlay.
“We don’t have a separate government bond portfolio or overlay on top. We have one mandate with all the instruments we need to hedge interest rate risk,” explains Kroon, who monitors the portfolio, mostly run internally, from his home while PGB’s offices remain shut on virus lockdown. It has engendered a flexible strategy that allows the fund to draw on swaps, futures and bonds to hedge. “We use swaps as part of our hedging programme, but in combination with bonds and futures depending on which ever instrument we find most attractive,” He notes, however, that the fund only uses swaps to hedge liabilities in longer maturities over 30 years because of the scarcity of long-dated government bonds.
In another arm to the strategy alongside the matching portfolio, PGB also runs a dynamic hedging programme that also uses swaps, futures or bonds. Here the focus is on interest rate levels, where Kroon and his team hedge more, or less, of the liability risk depending on how rates move - even if that movement is relatively small. “The higher the rates the more you hedge,” he explains.
It’s a flexible toolkit that has proved essential during the recent illiquidity in the swaps market. “Illiquidity has left us slightly less free in the instruments we can use so we have been using instruments other than swaps to decrease or increase the interest rate hedge. It all depends which instrument gives the best liquidity.”
Bid-offer spreads in swaps peaked as a result of low market liquidity at the height of the outbreak when equity markets fell most sharply. Although the fund is continuing to monitor whether to use swaps or futures, the illiquidity and diminished volumes that characterised the market then, have eased, he says. “It has stabilised recently which is making it easier to transact, and counterparties are willing and able to quote. The bid offers have come down a bit although they are still significantly wider than normal.”
Indeed, he links much of the uncertainty to the availability of counterparties. While some derivative counterparties (the pension fund has around ten) have been able to price “reasonably well,” others have withdrawn from the market and not bid when volatility has been at its highest. It’s added to the liquidity crunch, spiking costs in swaps and forcing the fund to use interest rate futures to hedge in some cases. “Some parties have only been quoting at very wide bid offers, which means we have to go back to our other derivative counterparties. Luckily we have enough counterparties left able to quote.”
It’s an experience that won’t hasten PGB’s take up of clearing. The fund hasn’t begun moving away from bilateral trading and shifting derivatives trades from CCPs to clearing. “We are able to clear via the CCPs, but we don’t use it at moment,” he says. “We trade frequently with counterparties because of our dynamic interest rate hedging strategy. I don’t see a pricing differential between cleared products and uncleared products - I would expect it to be the same.” One reason for not using LCH is a wait-and-see approach following Brexit, he adds.
Kroon describes the government’s fiscal response and the ECB’s promise of unlimited liquidity as “strong.” However, he doesn’t believe “we’ve seen the depths” of the corona crisis and predicts more volatility on the road ahead. “If economic growth is disappointing, market volatility will increase with ramifications for credit spread and equity markets, and illiquidity in fixed income markets.”
If markets enter another phase of extreme volatility, he says PGB’s strategy will remain the same with the team using futures and bonds to hedge if swaps get too illiquid and expensive. That said, if illiquidity makes it very challenging to adjust the hedging percentage in line with fund policy, the team will step back from the market altogether. “We will not trade at any cost,” he says. “Of course we will try to lower our hedge if rates go down and increase our hedge if rates go up, but if the costs are out of proportion, we will go back to our board and say we advise staying where we are for now.”