EUROPE – Consultancy Redington has said that pension funds need to widen their investment options in the current low-yield environment and cited the possible acquisition of inflation-linked swaps previously signed between utility companies and banks.

The Bank of England's recent rounds of quantitative easing (QE) and record low interest rates have forced pension funds to look for alternative sources of returns.

Meanwhile, new regulation such as Basel III has compelled banks to get inflation swaps signed with utility companies off their books, as uncollateralised derivatives exposure requires much greater capital.

John Towner, director at Redington, said: "Because they are regulated and because their revenue stream is linked to RPI, utility companies have a more predictable cash-flow profile, and issuing inflation-linked bonds often makes sense in terms of their capital structure."

However, as Towner stressed, these stable cash flows have led many utility companies to establish what are known as whole business securitisation (WBS) programmes, which enable them to issue debt more efficiently.

"As a result of the WBS structure, utility companies have certain requirements that govern the inflation-linked swaps they undertake with banks," Towner said. 

"And one important element is that the swaps tend not to be collateralised, meaning there is more credit and liquidity risk than with a traditional collateralised swap. 

"It is the compensation that pension funds can potentially receive for this risk that makes them attractive."

Towner went on to say that acquiring these kinds of swaps from banks, looking to reduce assets in light of new capital requirements, made sense for pension funds, particularly because the swaps delivered long-dated, inflation-linked cash flows that matched well with pension liabilities.

Utility companies could potentially look at some collateral mechanisms to reduce the credit risk attached to those swaps, he said.

However, he added that putting in place these mechanisms might prove difficult due to their business securitisation requirements.

"Although the deals tend to be uncollateralised, many of the swaps have features that mitigate the credit risk, such as bringing forward some of the back-ended cash flows," he said.

"But really, what the pension scheme wants to get is attractive compensation for the credit risk it is taking in an uncollateralised exposure, and, given that banks are feeling the effects of tighter capital requirements, some pricing is looking attractive indeed."

Towner conceded that a number of implementation issues remained, such as bridging the valuation gap, as well as making pension funds comfortable enough to take the assets onto their books at all, given the credit exposure to utility companies.

Asset managers running LDI strategies on behalf of the pension fund would therefore need a dedicated team looking at processes around setting swap-counterparty risk limits, while also looking at its bank counterparties in terms of CSA agreements. 

Additionally, the pension fund would need to look at the timeframe issue of the swap, as getting the deal between the bank and the pension fund done would depend on what was happening in the inflation market.

When inflation moves, Towner said, pension funds have to move extremely quickly as well, if they want to acquire such swap from a bank.

He added that getting a deal done between the bank and the pension fund would depend not only on pricing and market levels, but also on the pension fund's operational and legal requirements. 

"These are assets that bridge the skill sets of both credit and LDI managers, and it is finding the right manager in this respect that is key," he said.

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