Patrick Dunnewolt, Jeroen van Bezooijen
European Market Infrastructure Regulation (EMIR)
requires central clearing for derivative transactions. It has been in
effect since 2013, but many pension funds and other institutional investors
have been granted a temporary exemption until April 2018. This has
important implications for the management of large in-house derivative
portfolios, such as liability-matching swap overlays.
Derivative positions such as these are typically collateralised with
government bonds under bilateral agreements. With central clearing, bonds
can still be used for posting initial margin, but daily variation margin
needs to be posted in cash. This raises three key questions:
Liability-matching overlays face margin calls when interest rates rise, so
it is particularly important to have a robust collateral strategy in place
if yields continue to rise from today’s ultra-low levels.
The amount of cash required depends on two factors:
In our experience, it is often hard for institutions to raise cash at short
notice from their existing portfolio because assets are allocated to a
range of mandates. Doing so is typically disruptive, and sometimes even
impossible. We assume, conservatively, that in practice it could take up to
a year to raise cash.
Let’s consider a €1 billion pension fund with an overlay that matches 30%
of its liabilities, which have a 20-year duration. With an assumed 12-month
period to rebuild the cash pool, a cash allocation of about €100 million
(10% of total assets) would be required to withstand the largest historical
move in long-dated swap rates of 1.7 percentage points from 4.7% in January
1999 to 6.4% in January 2000. (€1 billion x 30% x 20 years x 1.7% equals
about €100 million, or 10%).
This is a substantial cash allocation compared with typical institutional
cash holdings of at most 1%-2%. Although this is a hypothetical example, we
believe it is representative of many investors with in-house
liability-driven investing (LDI) overlays.
The simplest way to raise cash would be to sell down part of the current
portfolio. But selling 10% of assets would materially change the strategic
asset allocation and reduce the long-term return of the portfolio. We
estimate this could cost our hypothetical €1 billion pension fund between
€15 million and €45 million in expected returns over the coming 10 years
(see box for details).
However, other approaches are more efficient. Investors could sell assets
but maintain exposure to these asset classes and use derivative and other
similar transactions to maintain overall market exposure. For example, this
could be done by:
We illustrate this with an asset allocation example: We replace 5% of the
10% passive equity exposure with futures and repo 5% of the 30% in
government bonds. This would raise the required cash allocation of 10%,
without changing the total exposure of the portfolio (see Figure 1).
This approach, of course, would increase the derivative exposure and
therefore add to the amount of cash the investor would need to hold to meet
It is highly unlikely that the entire cash allocation would be required
within days, or even weeks. The cash allocation is sized to cover a
worst-case adverse move in the mark-to-market value of the derivative
overlay over a 12-month horizon. Therefore, it would not make sense to
invest all of it in overnight money market instruments.
A better approach would be to map the mark-to-market volatility of cash
holdings to a specific time horizon. Cash that may be required immediately
would need to be invested in overnight money market funds, and it would be
subject to the negative yields associated with such investments that have
no mark-to-market price volatility.
But cash that will not be required for a few weeks or months could be
tiered and potentially earn higher yields. With a time horizon of just a
few months, investors potentially could earn far higher yields by accepting
some minimal fluctuations in mark-to-market prices.
Consider one such tiering:
As long as the risk of suffering default loss remains negligible, which it
would with such shorter-term, high quality investments, tiering of this
sort could potentially improve the cash portfolio yield by over 60 basis
points relative to the Eonia, the Euro OverNight Index Average (see Figure
EMIR will require investors with derivative overlays to hold more cash. It
is important to limit the impact of this on long-term investment
performance by efficiently raising and managing these cash pools.
Figure 3 compares three different ways to raise 10% cash from our
hypothetical investment strategy of 30% equities, 50% bonds and 20%
Past performance is not a guarantee or a reliable indicator of future
Investing in the bond market is subject to certain risks including market,
interest-rate, issuer, credit, and inflation risk; investments may be worth
more or less than the original cost when redeemed. High-yield, lower-rated,
securities involve greater risk than higher-rated securities; portfolios
that invest in them may be subject to greater levels of credit and
liquidity risk than portfolios that do not. Bank loans are often less
liquid than other types of debt instruments and general market and
financial conditions may affect the prepayment of bank loans, as such the
prepayments cannot be predicted with accuracy. There is no assurance that
the liquidation of any collateral from a secured bank loan would satisfy
the borrower’s obligation, or that such collateral could be liquidated.
Investing in foreign denominated and/or domiciled securities may involve
heightened risk due to currency fluctuations, and economic and political
risks, which may be enhanced in emerging markets. The use of leverage may
cause a portfolio to liquidate positions when it may not be advantageous to
do so to satisfy its obligations or to meet segregation requirements.
Leverage, including borrowing, may cause a portfolio to be more volatile
than if the portfolio had not been leveraged. PIMCO strategies utilize
derivatives which may involve certain costs and risks such as liquidity,
interest rate, market, credit, management and the risk that a position
could not be closed when most advantageous. Investing in derivatives could
lose more than the amount invested. There is no guarantee that these
investment strategies will work under all market conditions or are suitable
for all investors and each investor should evaluate their ability to invest
long-term, especially during periods of downturn in the market.
Diversification does not ensure against loss.
Statements concerning financial market trends or portfolio strategies are
based on current market conditions, which will fluctuate. There is no
guarantee that these investment strategies will under all market conditions
or are suitable for all investors and each investor should evaluate their
ability to invest for the long term, especially during periods of downturn
in the market. Investors should consult their investment professional prior
to making an investment decision.
This presentation contains the current opinions of the manager and such
opinions are subject to change without notice. This presentation has been
distributed for informational purposes only and should not be considered as
investment advice or a recommendation of any particular security, strategy
or investment product. Information contained herein has been obtained from
sources believed to be reliable, but not guaranteed. No part of this
presentation may be reproduced in any form, or referred to in any other
publication, without express written permission.
PIMCO Europe Ltd
(Company No. 2604517) and PIMCO Europe Ltd – Italy
(Company No. 07533910969) are authorised and regulated by the Financial
Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in
the UK. The Italy Branch is additionally regulated by the CONSOB in
accordance with Article 27 of the Italian Consolidated Financial Act. PIMCO
Europe Ltd services and products are available only to professional clients
as defined in the Financial Conduct Authority’s Handbook and are not
available to individual investors, who should not rely on this
communication. | PIMCO Deutschland GmbH (Company No.
192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and
regulated by the German Federal Financial Supervisory Authority (BaFin)
(Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance
with Section 32 of the German Banking Act (KWG). The services and products
provided by PIMCO Deutschland GmbH are available only to professional
clients as defined in Section 31a para. 2 German Securities Trading Act
(WpHG). They are not available to individual investors, who should not rely
on this communication. | PIMCO (Schweiz) GmbH (registered
in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41,
8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products
provided by PIMCO (Schweiz) GmbH are not available to individual investors,
who should not rely on this communication but contact their financial
PIMCO is a trademark of Allianz Asset Management of America L.P. and
Pacific Investment Management Company LLC, respectively, in the United
States and throughout the world. © 2017, PIMCO.
The information on this web site is for residents of Luxembourg only.
All material contained on the Exchange-Traded Funds section of this website is purely for informational purposes only and is not intended as investment advice. Investors should seek financial advice before making any investment decisions.
The products and services are available only to residents of those jurisdictions. The information on this web site does not constitute an offer for products or services, or a solicitation of an offer to any persons outside of Luxembourg who are prohibited from receiving such information under the laws applicable to their place of citizenship, domicile or residence. Copyright ©2017 PIMCO Europe Limited. All rights reserved.
Are you sure you would like to leave?
You are currently running an old version of IE, please upgrade for better performance.