DerivativesMarkets: Swaps sizzle on call for Danish ALM change


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Asset managers, pension funds and derivatives specialists across Europe need to be aware of the potential changes in Danish ALM activity. Several Danish pension funds and life insurers have written to the Danish Financial Services Authority suggesting that they be allowed to change their discount curve for liabilities from Danish government bonds. Christine Joseph-Haller looks at the implications for the euro and Danish krone fixed-income markets.

A version of this article first appeared in Total Derivatives. Total Derivatives is the prime source of real-time news and analysis of the global fixed income derivatives markets.

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, says the regulator’s deputy director, Per Plougmand Bærtelsen.

“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 says. “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 much more leeway.

“They’ve made this recommendation because the budget’s improved. There’s no need to issue more government bonds and now Danish government bonds (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 quickly tightened 1bp to 2bp since the proposal,” says one swap trader.

Better liquidity in the derivative market compared with 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,” says a source at a Danish pension fund.

A domestic effect or euro ripple?

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 10bp-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 volatility.

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

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

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

While this source concedes that the euro market could also be affected, given that the Danish swap curve trades above the euro curve, it makes it more attractive to receive Danish krone. The unadjusted 10-year Danish krone/euro swap spread was around 12bp in mid January and the Danish krone/euro five-year spread is around 9bp. Note that Danish asset swap spreads are also much wider than in euro: at around 38bp in 10-year Danish spreads versus only in the low 20bp area in 10-year European government bond spreads. That said, the euro market is considerably more liquid than the Danish krone market and Danish funds have been big users of euro swaps and options in the past.

A pension fund source points out: “This doesn’t necessarily mean that everyone will jump ship and start using Danish swaps as a hedging tool.” Rather, funds would use krone swaps as a measure.

Another pension fund source sees a valuation difference “in the early teens” but highlights that this won’t necessarily decrease demand for duration. “There will still be a similar duration gap. It doesn’t make a big difference to liabilities if you discount on 4% or 4.1%. 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 sees 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, although it is understood they are among the larger players in the market. The largest Danish pension fund, ATP, is not one of them. The fund is governed by a special law and has already used the Danish krone swap curve since 2002.

A version of this article first appeared in Total Derivatives. Total Derivatives is the prime source of real-time news and analysis of the global fixed income derivatives markets.