Derivatives market: Swaps sizzle on call for Danish ALM change

Christine.Joseph-Haller@TotalDerivatives.com Danish life and pension funds suggest changing discount curve
 

The Eurozone and Danish swap markets are abuzz with talk of potential major changes in Danish ALM activity.  In early January several Danish pension funds and life insurers wrote to the Danish Financial Services Authority, suggesting that they be allowed to change their discount curve for liabilities from Danish government bonds (plus a spread) to Danish swaps. Danish swap market sources and Danish pension fund sources see a “good” or “pretty likely” chance that the regulator will act on the suggestion.

The Danish FSA will consider industry demands for a change in the discount rate that is used for the calculation of pension fund liabilities, the regulator’s deputy director Per Plougmand Bærtelsen told Total Derivatives.

“The industry has sent a proposal that we will look at. But it is too early in the process to say when we will give a response,” Bærtelsen said. “We have not taken a view on it yet.” 

The Danish budget surplus has made government bonds trade very rich at the moment, and well through Bunds.  This makes them an expensive valuation tool as a discount rate for liabilities. Using the higher yields of the Danish swap curve would give funds considerably more leeway.

“They’ve made this recommendation because the budget’s improved.  There’s no need to issue more government bonds and now DGBs trade through Bunds.  That makes it unfair to discount with a negative spread and so they want to change to the swap curve.  It seems like a fair demand.  Danish asset swap spreads have already tightened 1-2bps since the proposal,” said one swap trader. 

Better liquidity in the derivative market compared to the DGB market is also seen as a plus.  “People would prefer to use swaps as a measure because they are more liquid than DGBs.  There are no strange prices out there – those can really affect valuations,” said a source at a Danish pension fund.

Impact mulled: A domestic effect or EUR ripple over?

Considerably less consensus exists on the impact of this change, if adopted.  One swaps trader sees changes to the valuation of the whole sector prompting a much-reduced need for duration: “If this suggestion is accepted, pension funds will have to react.  They’d be valuing liabilities at higher yield levels – I’d say around 10bps-plus – and this reduces their need for duration.”  A reduced need for duration would typically lead to paying in long-dated swaps and selling of vol.

There is the clear possibility of a “ripple over” effect into the Eurozone.  Danish accounts have actively hedged in the more liquid EUR swap and vol markets previously, and could continue to do so.  The 10s/30s curve has already steepened up in 2007, mainly as a result of large supply washing over the market, and the January ECB conference, which was less hawkish than expected.

Sweden implemented similar changes to the discount curve back in mid-December but the 10s/30s EUR swap curve didn’t react at all.  In fact it hit all time lows right around that time.  Still, when Sweden changed its traffic light regulations in Q4 2005, the 10s/30s EUR curve steepened sharply and the EUR market reaction was actually stronger than that in SEK. 

Other sources are more sanguine on a potential Danish move, saying that the effect is hard to measure directly: “If the law is changed, it’ll give the funds more freedom but not necessarily have a direct effect.  It’ll depend on their rates/equity balance of course, but if, say equities go down and rates go up, then they’d have more freedom,” said another swap trader.  He expects decreased demand for DGBs and increased receiving of DKK swaps. 

While this source concedes that the EUR market could also be affected, given that the Danish swap curve trades above the EUR curve, it makes it more attractive to receive DKK.  The unadjusted 10y DKK/EUR swap spread is around 12bps at the moment and the DKK/EUR 5y5y spread is around 9bps. Note that Danish asset swap spreads are also much wider than in EUR: at around 38bps in 10y Danish spreads vs only in the low 20s in 10y EGB spreads.  That said, the EUR market is considerably more liquid than the DKK market and Danish funds have been big users of EUR swaps and options in the past.

Pension fund sources are quick to point out that “This doesn’t necessarily mean that everyone will jump ship and start using Danish swaps as a hedging tool.”  Rather, funds would use DKK swaps as a measure. 

One pension fund source sees a valuation difference “in the early teens” but highlights that this won’t necessarily decrease demand for duration.  “There’ll still be a similar duration gap.  It doesn’t make a big difference to liabilities if you discount on 4% or 4.10%.  You’d have the same duration gap or rate mismatch, the difference is in the reserves.  You’d get more of a buffer.”  The source saw more of an impact on Danish asset swap spreads than anything else, with bonds losing relative to swaps although the effect would be tempered by reduced supply keeping bonds relatively supported.

The identities of the parties writing the letter have not been divulged, though it is understood they are among the larger players in the market.  The largest Danish pension fund, ATP, is not, however one of them.  The fund is governed by a special law and has already used the DKK swap curve since 2002.