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The Actuary The magazine of the Institute & Faculty of Actuaries
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Real yields on new swaps fall below 0%

Ralph Frank, head of solutions at investment adviser and fiduciary manager Cardano UK, explained: "The yields on interest rate swaps, commonly used by pension funds to hedge the interest rate and inflation risks in their liabilities, have fallen dramatically in the last few months, to around 3.5% p.a. or lower for all swaps. This is mainly due to concerns in the near term about the European debt crisis and stalling global economic growth as well as longer-term deleveraging. At the same time, the banks that sell inflation swaps are holding their pricing at around the 3.5% p.a. level for longer-dated inflation swaps. They appear to be assuming that 3.5% is a key trigger level for pension funds to buy inflation protection. The result is that the real yield - the difference between the interest rate and inflation swap rate - is negative across the whole yield curve.

"Interestingly, the yield on index-linked gilts has not fallen to nearly the same extent. This means that index-linked gilt yields currently look very attractive compared to the equivalent swaps, at 0.3 - 0.4% p.a. higher.

"Although it may seem like a very bad time to hedge liability risks now, negative real swap yields could be with us for some time. Many pension funds have failed to allow for the likelihood of interest rates remaining very low for many years to some. For our solvency management clients we have been practically fully hedged so far this year, and remain fully hedged. We have also proposed that our advisory clients hedge a significant proportion of their liability risks for some time."