Get real: asset managers ditch swaps for loans

With swaps markets becoming less liquid and more expensive, especially for longer-dated trades, some pension funds are winding back the clock and sourcing long-dated, real assets to hedge their liabilities. But the strategy carries its own risks, reports Tom Osborn

Sumit Mehta, investments manager, Legal & General

Interest rate swaps are losing their appeal. Faced with new clearing and bilateral margining rules – and the prospect of huge cash calls during times of stress – asset managers with long-dated liabilities to hedge are increasingly turning to real assets instead.

Or, to put it another way, pension funds and insurers are replacing banks as lenders, particularly in long-term, index-linked loans to infrastructure projects, social housing partnerships and the like, where the associated regulatory burden has resulted in banks pulling back. Many of these firms see a once-in-a-generation opportunity to boost yields while reducing their reliance on securities and derivatives markets, and at least some banks accept this may be a more natural home for the risk.

"I think we're in the relatively early stage of a market revolution, in which insurers and pension funds are becoming much more involved in the financing of real assets. Not just social housing, but also infrastructure and export credit agency loans. Fundamentally, over a long-term perspective, the liquidity coverage ratio and other changes in capital treatment mean it makes sense for these long-term risks to end up on insurers' books," says Simon Hotchin, co-head of insurance clients for Europe, at HSBC in London.

But while it might be a systemically elegant solution, it poses challenges for all involved. For dealers, the money made from originating and syndicating loans is unlikely to make up for lost swaps revenue; for asset managers, the new hedges require risk management skills that some have lost and others never had; and, for borrowers, costs might increase.

"In essence, we're going back to where we were in the 1980s, where long-term funders were able to buy long-term assets at the right price. Banks have been subsidising cheap funding with ancillary income from associated swaps and structured products, but this is more difficult for them now. In theory, borrowers should be paying the right price for long-term credit, which is, arguably, not what was happening when the banks were underwriting every deal," says William Nicoll, co-head of alternative credit at M&G Investments, the fund manager owned by UK insurer Prudential.

Over a long-term perspective, the liquidity coverage ratio and other changes in capital treatment mean it makes sense for these long-term risks to end up on insurers' books

According to a report published by consultants McKinsey last year, if institutional investors hit publicly declared targets for allocations to infrastructure investment, doubling their share of funds under management from 3% to 6%, the supply of credit from the sector would increase by $2.5 trillion by 2030.

Historically, a place on such deals was the preserve of larger, diversified insurance and fund management groups. London-listed Aviva has long held a vast pool of commercial mortgages, a large chunk of which are set against its long-dated annuity exposures. Scottish Widows Investment Partnership – the investment manager sold by Lloyds Banking Group last year to Aberdeen Asset Management – is also said to have engaged in various internal risk transfers with Lloyds from 2011, taking on long-dated loan portfolios and using them as annuity hedges.

But now, managers with little or no experience in the sector are getting in on the act. In February, AllianceBernstein's European arm made an aggressive entrance into European infrastructure investment, hiring a team of specialists to buy up loan portfolios from banks and offer capital to new investments. The firm's primary motivation was the search for yield, says Erik Vynckier, its London-based chief investment officer for insurance, with the reduced use of swap overlays simply a happy side effect of smaller government bond portfolios.

"Infrastructure investment constitutes both a hedge and a positive investment, in that it's a return-generating asset that matches part of our liabilities. If you do a rates trade, you trade at the swap curve. Here, we're talking about committing assets on the balance sheet: we want to see a significant return before we'll invest. You'll never be able to eliminate all derivatives trading – your asset will never precisely match your liability, so you'll have to even it out – but it will certainly mean we'll need to use far fewer going forward," says Vynckier.

Other firms are acting on a conviction that the swap market is becoming less liquid, more expensive and potentially dangerous. Under existing credit support annexes (CSAs) – the industry standard collateral agreement – dealers will often accept a wide range of assets as security, and may take a certain amount of unsecured risk to some clients. This flexibility is about to vanish for good (Risk December 2013).

"In a world of bilateral CSAs, where dealers accepted a wide variety of assets as collateral, your natural preference is for swaps, because you've got flexibility and tailoring of cashflows. But, under central clearing, there is now a liquidity risk – certain market movements can cause huge collateral calls, which can only be met with liquid assets," says Sumit Mehta, London-based investments manager for Legal & General's (L&G) group treasury and investments team.

This liquidity risk is magnified because pension funds often use very long-dated, fixed-rate receiver swaps when hedging, which would slide out-of-the-money as interest rates rise. Speaking to Risk last year, PGGM Investments said it expected variation margin calls – which have to be paid in cash – of between €5 billion and €10 billion if interest rates jumped by 100 basis points.

Across the liability driven investment (LDI) community, there could be as much as £100 billion in swaps notional outstanding, according to one estimate, which translates into a per-basis point sensitivity to interest rates of £200 million, assuming an average duration of 20 years. Using those figures, a 100bp rates shock would generate an aggregate margin call of £20 billion.

Changing the hedging strategy does not mean leaving the risk behind, of course. Instead of new-found swaps liquidity exposure, asset managers will face old-fashioned credit risk. For some firms, this could involve internal restructuring to make sure investment teams with credit expertise are talking to LDI managers, who have greater experience with derivatives.

"Essentially, you're combining a rate and inflation hedge, but taking on credit risk – and that is frequently the most essential element to understand. That makes it important for managers to have a cross-asset focus; there should be integration between LDI programmes and sector-specific investment teams. The investment team should have the ability to structure and value an inflation-linked investment, while the LDI teams should be able to integrate the booking and risk management of such investments into a typical LDI strategy," says L&G's Mehta.

"In infrastructure debt or illiquid private debt, you need large teams of analysts in-house to be successful," agrees M&G's Nicoll. "If you haven't done it before, it's very difficult to find, analyse and execute deals. That makes me think there's a difference between the number of people talking about this kind of investment and the number who are actually able to do it."

The level of credit risk for these assets is fairly low, but every borrower is different, so asset managers are unlikely to take much on trust. According to a study of default and recovery rates for project finance bank loans published by Moody's Investors Service in March, the 10-year cumulative default rate for the infrastructure sector stands at 6.6%, an increase from 5.2% a year earlier. By year 10, the marginal default rate for project finance loans is roughly the same as for A-rated corporate debt, the agency found.

Offsetting liabilities

Finding an effective hedge is not only about selecting solid borrowers – it's also about working out how effectively it will offset the shifting profile of a fund's liabilities, which AllianceBernstein's Vynckier warns can be more slippery than with a bond or swap. "Their structure makes them more complicated instruments than the strictly defined gilts or swaps you have on your book; there, you have a term sheet and no optionality. Here, there is a certain optionality inherent, even in fairly well-fitting hedges for an annuity book: the borrower has the option to repay early, but the lender also has the option to review terms," he says.

Firms requiring new expertise have a couple of options, according to HSBC's Hotchin. The first is to hire a small team of full-time specialists or reallocate investment professionals from other roles; the other is to outsource to an external asset manager. Even the largest insurers sometimes opt for the latter approach. In 2012, Swiss Re announced a $500 million investment in infrastructure businesses and assets, but handed the mandate for sourcing and managing them to Macquarie, for instance.

Others take the opposite tack. Last year, when announcing the launch of its first infrastructure debt fund, German insurance giant Allianz hired a team of specialist investors to do the job in-house. Likewise, when AllianceBernstein made its move into infrastructure in February, it took on teams of credit analysts with both a specialist and macro focus, says Vynckier.

"Both our US real estate and European infrastructure build-out have relied on new hires of experienced staff with an extensive banking or industry background. On occasion, ratings for investments are also sought from an independent rating agency," he says.

As a result of the potentially lengthy lead times involved in that process, investors need to have patience while a manager builds up a portfolio, Vynckier adds. It can take anywhere from six months to two years to get to that point, but it is a prudent approach to entering a new market, he insists.

Dealers can also help firms get to grips with the market, argues HSBC's Hotchin; particularly the so-called solutions groups that many banks now deploy on a more-or-less pro bono basis to help clients work through complex problems (Risk April 2014).

"I think there's a lot of work to be done on the part of dealers' solutions groups to help investors understand how the characteristics of these assets can fit into an asset and liability management framework, as well as helping to explain the way they are treated by Solvency II. If an insurer is investing in an asset class it hasn't had a presence in before, that requires a mandate change. There's a lot of dialogue, analysis and handholding to be done to begin with," says Hotchin.

Other old certainties of the derivatives market are also diminished; rather than being wooed by banks keen to win a share of a firm's swaps business, fund managers buying up loan portfolios will instead be facing their dealer across the negotiating table, says Vynckier.

"This is all secondary business, bought from banks that are trying to shrink their balance sheets. The spread you can achieve depends on your negotiating power. You can't log on to Bloomberg and see streaming prices," he says.

Big buy-side firms might be tempted to disintermediate banks and lend directly, but L&G's Mehta – who used to work in derivatives structuring at Royal Bank of Scotland – does not expect this to be a common thing, for now at least.

"I think there is still a role for the banks in engaging in traditional risk transformation – taking on the initial, short-dated risk, which they're better geared to capture – and distribution, to make sure the assets suit the investor profile," he says.

This does not fill some bankers with joy. "Clearly, banks' overall profitability will be lower, because the quantum of deals going through the market will be much lower. Once an investor has bought a social-housing loan, a good number of loans will be held to term. With a derivatives book, hedges need to be readjusted periodically, because liability and cashflow projections change. The question now will be which banks can originate the kind of assets that insurers and pension funds want to hold, and what kind of fees can they justify on the back of it? Is that going to make up for the lost earnings from derivatives? Probably not," says one veteran banker.