Pension funds’ hedging dilemma
Pension funds have no shortage of concerns: their funding deficits are rapidly growing in the current low-return environment, and ageing populations are stretching their liabilities.
But a recent survey of pension funds trustees by French business school EDHEC has found that their biggest worry, cited by nearly 77% of the respondents, is the risk that their sponsor — the entity or employer that administers the pension plan for employees – could go bust. Yet 84% of respondents fail to manage the sponsor risk.
So how do you hedge against such a risk?
You could buy credit default swaps of the sponsor company or buy out-of-the-money equity put derivatives to seek protection. But both options are costly and illiquid. Moreover, it might send a negative signal to the market: after all, if the company’s pension fund is seen effectively shorting the company in an aggressive manner, investors may wonder “What do they know that we don’t?”
Erwan Boscher, head of Liability-Driven Investing and Fiduciary Management at AXA Investment Managers, says:
“Using market instruments like CDS and out of the money equity puts were suggested as a way of hedging sponsor risks, but we seldom see them implemented because of the cost, liquidity or reputational risks for the sponsor.”
Central banks and the next bubble (2)
In the previous bubble blog earlier in the week I wrote that G4 central bank balance sheets are expanding to a whopping 26% of GDP.
In what Nomura’s Bob Janjuah called “Monetary Anarchy”, some analysts worry that central bank liquidity expansion is a timebomb which if/when it explodes would have very negative consequences.
Swiss private bank Lombard Odier, weighing in on the debate, warns that not only has the quality of central bank balance sheets deteriorated, there has been no visible impact on the real economy.
Stephanie Kretz, member of the investment strategy team for private banking at Lombard Odier, points out that a sharp fall in the money multiplier, defined as the ratio of broad money (M3) to the monetary base, means the impact on the real economy has been almost non-existent.
What about the real economy? Ballooning and riskier central bank balance sheets will not generate sustainable growth or reduce unemployment and debt levels, but could well induce at a later stage unintended consequences that include bouts of hyper-inflation, loss of trust in fiat money and loss of central banks’ credibility as to their capacity to maintain strong currencies and stable prices.
The huge increase in the monetary base has not flowed into the real economy, and is sitting in the excess reserves of still reluctant-to-lend banks whilst the world is deleveraging, thus capping the demand for credit.
What happens when a recovery eventually kicks in, interest rates go up, the velocity of circulation of money comes back and real economy is flooded with paper currency that does not correspond to real human production? Monetary base expansion will need to be reversed in large, non-incremental steps if it is to be non-inflationary. This is uncharted territory for central banks and poses significant longer-term policy risks.
Calling CCCs
Junk bonds have enjoyed a rally since the start of the year but investors are facing a dilemma.
Should you buy larger, more liquid bonds that have already risen significantly, or buy smaller, illiquid bonds that have an attractive price?
Barclays Capital says triple-C rated bonds — the riskier segment of the junk space — are beginning to catch up with less risky issues because higher rated bonds have increasingly run into “call constraints”.
(For non bond geeks: Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date. )
Barclays says as of Wednesday’s close, 71 percent of callable BBs and 57 percent of callable single Bs were trading above their next call price, compared with just 29 percent of CCCs.
It’s the exit, stupid
Anyone wondering what ghoul is most haunting investors at the moment could see it clearly on Tuesday — it is the exit strategy from the past few years’ central bank liquidity-fest.
Germany came out with a quite positive business sentiment indicator, relief was still there that Greece had managed to sell some debt a day before, and Britain formally left recession – albeit in a limp kind of way.
But what was the main global market mover? It was China implementing a previously announced clampdown on lending.
Doesn’t bode well for when the euro zone stops lending banks low-interest money, Britain stops buyng gilts and the Federal Reserve raises interest rates.
The Big Five: Themes for the Week Ahead
Five things to think about this week:
CENTRAL BANKERS IN A HOLE – The global economy and financial system appear on the road to recovery but that is in large part due to unprecedented official stimulus that will have to be withdrawn at some point – the questions investors want answered are when, and how. Central bankers no longer appear to be quite as shoulder to shoulder with one another on coordinated policy as they were last year in the aftermath of Lehman’s collapse.
CHINA STOCK WATCHING – It is August, liquidity has dried up with the summer holiday season in full swing, and investors are palpably more cautious about the economic outlook now than they have been for months. It is against this backdrop that that the Chinese stock market is emerging as the focal point and driver of all other asset markets. The Shanghai Composite technically slipped into bear market territory earlier last week, shedding 20 percent in the two weeks from Aug. 4 to Aug. 19 on profit taking from the 90 percent surge this year. There is no major Chinese economic data scheduled for release this week, leaving thin markets at the whim of sentiment in what is a notoriously volatile stock market.
GROWTH FOUNDATIONS – The United States, Britain and Germany unveil revised estimates of Q2 economic growth. Revised GDP figures rarely garner much attention but with initial estimates from Germany, France and Japan earlier this month all showing that these countries exited recession in the last quarter, investors will be looking for further evidence the world economy has turned the corner. The hard data is stronger now than it has been for some time but is the global economy building a solid base for recovery, or is it more likely to buckle were authorities to begin withdrawing the massive fiscal and monetary stimulus?
ABNORMALLY NORMAL MONEY MARKETS – A veil of normality continues to cloak interbank money markets, with Libor at record lows and some closely-watched measures of money market health like Libor/OIS spreads and the TED spread almost back to levels seen before August, 2007. But that is only thanks to authorities’ liquidity injections, guarantees and asset purchases worth trillions. Banks have hoovered up this free or ultra-cheap money but still are not feeding it into the real economy, with lending to business and households still patchy at best. Euro zone M3 money supply figures for July are expected to show another slowdown in the rate of growth, to 3.3 percent on the year from 3.5 percent in June. SAFE AS HOUSES? – Figures will show how the U.S. housing market, the epicentre of the global financial crisis, is faring four and a half years on from its peak. The Case/Shiller house price index is expected to show the annual pace of price declines slowed again in June, fuelling the belief that the market has bottomed. But the number of foreclosures is high as the U.S. labour market remains weak, and the national housing market stock remains high by historical standards. Economists say there will be no sustainable recovery of the financial system and economy without a durable recovery in the US housing market.
Investment lay offs are real issue to be dealt with more consciously. People need to get more prepared to face even a worst tomorrow.
Call that a money market fund?
Attempts to tidy up the European money market funds (MMFs) sector after last year’s turmoil have stirred up a hornets’ nest, with some providers arguing that the new definitions from trade bodies IMMFA and EFAMA don’t go far enough.
2008 was a testing time for the sector which sells a promise of providing instant liquidity with a little yield. In recent years so-called enhanced or dynamic MMFs promised extra yield by investing in securities with longer dated maturities or asset-backed securities that quickly became illiquid in the credit crunch.
When investors panicked and made a run on these funds, some broke the buck – like the US’s Reserve Primary Fund, whilst others had to suspend redemptions – such as BNP Paribas’s Parvest Dynamic ABS.
To try and restore confidence, and help investors make a distinction between the conservative funds and those that are more yield-seeking, industry associations IMMFA and EFAMA are reclassifying the European sector into “short term” MMFs, with weighted average maturities of 60 days or less, and “regular” MMFs, with weighted average maturities of up to a year.
Those funds running weighted average maturities of over a year – said to comprise some 100 billion euros in assets – will be thrown out of the sector after a lengthy transition period which runs until end-June 2012.
But market participants such as Laurie Carroll, of BNY Mellon Cash Investment Strategies, and Chris Oulton, CEO of independent MMF specialist Prime Rate Capital, argue that the double-headed definition is confusing as short-term and regular MMFs have very different risk profiles.
Oulton believes that “regular” MMFs shouldn’t be called MMFs at all: “A 12-month interest rate exposure doesn’t fit the expectations of the money market fund investor, which is that you should get your cash back when you want it, not a return on your cash.”
