NETHERLANDS - Mercer has urged Dutch pension funds with large interest hedges to take profits on swaps and government bonds, as the 30-year swap rate plunges to its lowest level in history.

Investors spooked by the euro-zone crisis and falling equity markets have flocked to 'safe-haven' assets, such as German government bonds, which in turn has brought the swap rate down to just 2.38%, according to Mercer actuary Dennis van Ek.

Van Ek said the increasing value of euro-denominated bonds could be turned into profit by swapping long-term fixed income investments for short-term ones.

"Given the low interest level, the odds of a further considerable interest drop have diminished, and pension funds' coverage ratios will improve if the interest level rises from the current low level," he said. 

He pointed out that the three-month average of the forward curve - the current criterion for accounting liabilities in the Netherlands - was 2.55%.

"This is the same level as at year-end, when the [regulator] introduced the three-month average as a new, temporary discount rate to relieve pension funds from the volatile
daily forward curve," Van Ek said, adding that the "accounting fiction" would no longer work.

"Without the three-month average of the discount rate, the funding of Dutch pension funds would be again at 94%," he said.

"And if the 30-year swap rate and equity markets remain flat, the average coverage ratio based on the three-month average discount rate will also be 94% after three months.

"In this scenario, the average funding will be 4 percentage points short of the level at year-end."

Van Ek said small and medium-sized pension funds in particular - which tend to hedge a large proportion of their liabilities - should consider cashing in.

"They should at least have a strategy in case the 30-year swap rates fall further - to 2%, for example, or even 1.5%," he said.

He said two of the consultancy's clients would this week swap €40m of long-term swaps and German government bonds for short-term German government paper.

"This way, they can benefit from the increased value of swaps and German government bonds, such as 30-year German loans, which have already increased by 6% in 2012, after a rise of between 10% and 20% last year," he said.

He also cited 30-year government paper issued in 1993 that is currently valued at 150%.

"It is sensible to cash in, in part, now and have a strategy in place for taking full profit before swaps and long-term bonds fall following an increase in interest rates."

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