Pension Fund Hedging
Pension Fund Hedging

Pension Fund Hedging


Pension Fund Hedging (Thread). US pension funds have had an assumed return of 6% since the late 90’s.Getting such returns in USTs was impossible. That pushed them further into equities. They also began utilizing more aggressive derivative strategies in fixed income.

A favorite trade devised by a famous pension fund advisory fund in the mid 2000’s took advantage of many features of the market to enhance yield:

1) longer term. 20y was the sweet spot

2) delay. In an upward sloping curve, a forward swap boosted yield. 3y20y was key.

3) skew. Payers swaptions traded at a higher vol than Receivers swaptions. So, they sold OTM (usually 1% out) 3y20y Payers. In exchange they bought OTM 3y20y Receivers at zero cost.

Let me throw out a few hypothetical numbers to make the situation clearer. Say, 20y yields were 4%. 3y 20y were 5% because of the forward swap in an upward sloping curve. They sold 1% out 3y 20y payers at a strike of 6% (remember the significance of that rate?)

In exchange, they bought 3y 20y Receivers at zero cost. If there was no skew, the Receivers would have a strike of 4%. Because of the prevailing skew, they ended up getting R4.25%.

Stand back and look at the trade. In an environment where long yields were 4%, pension funds sold a payers where they would receive 6%, something they’d love. But, the bank would only exercise their option if rates were even higher. If rates got higher than 6%, all of the problems of pension funds would be solved. Yes, they’d lose on this hedge, but they could back up the truck and get long USTs at above their assumed rate of return. This wasn’t a problem, it was their dream.

Now, let’s look at the other leg. If the curve stayed unchanged, and forward yields never got realized, they’d receive at 4.25% in a market where the prevailing rate was 4%. Genius trade. Now add in their real risk: rates dropping. Then it was even sweeter.

The US swaptions market is driven by the mortgage market with GSEs and Servicers being the largest clients. Every bank, in fact, the whole market is lopsided such that demand for Payers far exceeds the demand for Receivers resulting in the skew.

Here is a client who wanted to go the other way. The ideal rates window for them opened periodically. When it did, they tried to jam in as much as they could. When they began it was $1B a leg. More funds got on board and the size grew, and grew.

As the size grew, the number of banks involved dropped. Near the end they were doing $15B a trade. Treasury dealers refused to quote a price on the size. But, this amount of skew corrected the most lopsided large books. Option traders couldn’t say no.

The mark to market works in the funds favor if the upward sloping curve doesn’t get realized or rates fall. Remember the trade hinges on the assumption that in the case rates rise, the loss on the trade will be small compared to the opportunity of locking in higher rates.

But, pension fund managers are human. This was a great trade. Rates now weren’t even 4%. And the trade keeps paying off. So, they did more and more and more of it. Then rates skyrocketed up. They might well be okay if they could lock in the newer higher rates.

But, before they can deal with that they have the immediate problem of the growing negative MTM and with it frightening urgent margin calls. If they can’t survive the margin call today, they won’t have the opportunity to lock in higher rates later.

I’ve been thinking of writing this for some time now but hesitated to do so. Many of you are familiar with the details and the names involved. Please feel free to share. I’ve said everything I’m comfortable saying. I hope you find it helpful.

I’m no longer working. I’m very grateful for the opportunity I had and even more grateful to no longer be doing it.