Consultants: Derivatives Emerge As 'Quick and Dirty' Solution to Bond Shortage

(March 14, 2012) — As Ford Motor Co. shifts its $39.4 billion Dearborn, Mich.-based pension plan toward fixed-income in an effort to derisk — a familiar move among corporate schemes threatened by volatility — one obvious question becomes increasingly apparent.

What happens as megaplans in the United States start to buy up long-duration bonds, aggravating the problem of an already limited bond market?

With Operation Twist — the Federal Reserve’s strategy of shifting its portfolio by selling shorter-term debt and using the proceeds to purchase longer-term bonds — the Fed has been reducing the supply of longer duration bonds, consultants say, thereby exacerbating the situation. However, industry sources largely view the environment in a positive light, noting that if you’re a corporate plan sponsor and intend to extend bond duration to adopt a liability-matching strategy, you can do so using derivatives as opposed to having your hands tied with regards to the physical bond market.

“My first reaction to the market, if I were a treasurer, would be that it doesn’t entirely matter what the supply is in the physical bond market,” Pete Keliuotis, managing director of Strategic Investment Solutions, tells aiCIO. “Assuming I’m comfortable using derivative strategies such as interest rate swaps, I can manage my bond duration efficiently that way,” he says, adding that the ability of corporate plan sponsors to derisk is not constrained by the supply of bonds. “There may be counterparty risk, however, depending on the implementation strategy.”

In other words, there are other ways to lengthen bond duration for corporate plan sponsors without needing access to bonds themselves. The solution for many, then, is to increase duration synthetically with derivatives, using interest rate swaps and futures, for example.

Chris Levell of investment consulting firm NEPC echos a similar sentiment. “I don’t think that long duration investing depends on the availability of bonds,” Levell says. “Like many other risk management tools, there is much greater use of derivatives than physicals,” he says, asserting that many US and international plan sponsors use Treasury strips, futures, and swaps as part of their liability-driven investing glide path.

Furthermore, Levell notes that the UK — which has a relatively small corporate bond market — is still far beyond the US in terms of hedging activity. The UK has been more forced into the derivatives market due to lack of long-term bond supply at an earlier stage, and the US may be perhaps slowly following its lead.

JP Morgan, Citibank, Goldman Sachs, Morgan Stanley, Barclays and other large banks therefore emerge as the winners in this environment, according to consultants, as corporate plan sponsors seek help in entering into derivatives agreements — paying short-term floating rates in exchange for gaining interest on Treasury bonds. While Keliuotis acknowledges that the idea of counterparty risk has become a growing concern among schemes following the financial crisis, that concern has not thwarted the need for derivatives use but has instead forced plan sponsors to scrutinize their exposures and collateral more closely.

Meanwhile, consultants say that smaller schemes may be relatively more weary with gaining derivatives access due to their lack of resources and expertise in such complex investment vehicles.

So is the derivatives market a quick and dirty solution for corporate pension funds in the US — such as Ford’s — eager and desperate to derisk? According to many industry sources, derivatives and other hedging strategies have evolved as the next logical phase of investing as funds battle volatility along with interest rate and market movements amid an already constrained fixed-income market.