The yield curve on European government bonds is set to flatten or even invert from March this year as new regulations force the region's second-largest group of pension funds to change the profile of their assets.
Under new solvency regulations, Dutch pension funds will be required to match their assets and liabilities better after the poor performance of equities over recent years. That means they will become keen buyers of long-dated government bonds with maturities of between 10 and 30 years.
ABN Amro says the impact on the yield curve will make it even harder for pension funds to match liabilities. It also says that issuers and investors are often unaware of the scale of this issue and of the level of impact it might have.
The new Dutch pension solvency requirements will be implemented in the first half of this year, and the draft version will be published in March or April. But yield curves may start changing sooner than that, as pension funds seek to move early and get better prices for long-dated bonds.
The impact of this expected mass migration will be significant because Dutch pension funds are large. At e475 billion, they make up the second largest market of its kind in the eurozone, despite the Netherlands being a relatively small country. "Dutch pension funds already account for a significant portion of the European government bond investor base," says Harvinder Sian, a fixed-income strategist at ABN Amro. "If they decide en masse or in a trickle to benchmark against a different maturity class, that is a significant shift."
Idea of the effects
When similar solvency regulations were imposed in Denmark in 2001, demand for the long end of the euro curve rose, causing long-dated forward rates to drop from around 6.5% to nearer 5.25% in under six months. By September 2003, that rate had stabilized, but at just 5.75% it is still significantly lower than it had been at any time since 1999. Considering that Dutch assets are roughly four times Denmark's, that effect will be magnified.
And at the same time as Dutch pension funds move into long-dated government paper, French and German occupational pension funds will be doing the same thing.
Issuers are unlikely to be able to keep up with demand, and at this stage it is unclear what credit treatment corporate bonds will receive from the regulators. "Although this is going to be a strong story in 2004, to base your issuance timing just on this is difficult, owing to erratic flows," says Sian.
The key strategy for investors now is to move quickly. Sian says that some funds are already moving into longer maturities. "Investors need to pre-empt the real money accounts," he says. "Some of them are massive, so they won't be taking little chunks. If you are waiting for the real money to start moving, you will already have missed your opportunity."