UK - The first quarter of 2011 saw a 24% fall in levels of interest rate hedges by pension funds, research by F&C shows.
The firm's quarterly survey of investment banks said some £7.5bn of liabilities were hedged in the first three months of the year, compared to £9.9bn during Q4 2010. Inflation hedging was broadly unchanged with £7bn of liabilities hedged.
F&C said a number of serious world events gave rise to a flight to quality in Q1 as worried investors purchased safer haven assets such as government bonds. Middle East tensions and peripheral worries in Europe kept swap rates lower, while March saw the markets dominated by the earthquake in Japan and the threat of nuclear meltdown. Despite these events, strong global growth and inflation worries in the UK meant that swap rates rose over the quarter.
This survey shows that total return swaps (TRS) have enabled pension schemes to enter into synthetic gilt and index-linked gilt trades by financing the position for the medium term (typically six months to three years). Pension schemes continue to switch swap based hedges into gilts via TRS for the yield pick-up.
F&C head of derivative fund management Alex Soulsby said: "There were no great surprises in this quarter's survey. The decrease in nominal interest rate hedging appears to be due to a combination of the less attractive market swap levels and stagnant funding levels, causing pension funds to delay their hedging decisions.
"Inflation hedging in Q1 continued at similar volumes to recent months. Market levels also remained relatively stable over the quarter. Pension schemes' inflation concerns appear to be balanced by a reasonable level of inflation hedge supply."
The Bank of England's February Inflation Report showed an upward revision to the inflation forecast and lower growth expectations. The combination of strong inflation and weak growth is creating some concerns about stagflation, however F&C anticipates a continued, or increased, level of inflation hedging activity over the next quarter.
Respondents to the survey also predict inflation rates will increase again, with the extremely strong CPI data, rising commodity prices and a weak pound all given as reasons. They said when current RPI inflation is above 5.3%, a long term hedge at 3.6% looks attractive. However, there is significant upcoming index-linked gilt supply, which could dampen the price for long-dated implied inflation.
The majority of respondents also expect interest rates to rise. Banks view stronger economic data and rising inflation as causing momentum for the Bank of England to raise rates to combat high inflation, and the European Central Bank has already raised its rate, making it more likely that the Bank of England will follow suit, they argued.
The survey also found that although the majority of investment banks polled thought that swap spreads were moving closer to their positive pre 2008 levels, it was unclear whether they would ever fully revert or if a new standard has been created.
"The reasons behind the respondents' views are that swap spreads are generally driven by technical data in the short end and issuance and pension fund demand in the long end," the survey said.
"Swap spreads are likely to become less negative owing to the continued demand from pension funds. The positive carry that they receive from holding gilts outright or against swaps will continue to attract investors and to drive down their relative yields. If the UK economy continues to recover, and the deficit to decrease, there will be less debt issuance and a subsequent relative lowering of bond yields."
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