Domestic Bonds

Is Holland the next LDI shoe to drop?

Meen I dat nou!? A warning from Rabobank published yesterday suggests that a sharp rise in the Euribor interbank lending rate could do for the colossal Dutch pension funds what the Tory budget-induced ‘mini’ rise in gilt yields did for those from the United Kingdom.

Few people realize that, relative to the size of its economy, Holland has the largest pension system in the world, at around 214% of GDP last year, according to BNY Mellon.

In assets, it’s $1.9 trillion, according to the U.S. bank, and nearly all of it is in defined-benefit plans — exactly the kind of plan that likes liability-driven investing.

Dutch pension fund liabilities are pegged to the six-month Euribor curve, just as UK defined-benefit pension schemes are pegged to gilts: in either case, a sufficiently large increase in borrowing costs can quickly trigger absolute chaos significant liquidity problems.

© RaboResearch

However, Dutch pensioners should worry too much for now, writes Rabobank analyst Bas van Zanden.

Even if the Dutch government suddenly adopted Trussenomics and announced tens of billions in unfunded tax cuts (unlikely in the Netherlands), the effect on its domestic bond market would have less of an impact on Euribor (at the continent-wide) that Liz Truss’ fiscal event has had on UK gilt returns.

Dutch pension funds with liability-driven investment strategies would still be hit by margin calls if the prices of their holdings of domestic government bonds were to fall sufficiently, Rabobank notes. But these requirements probably won’t be too big and scary:

The size of the EU market is larger than that of the UK market. Both the exchange market and the repo market are larger, which means that the impact of Dutch pension funds on the market would be less and they probably have access to more liquidity.

But, but, but. . . Van Zanden warns that recent hikes in all major six-month rates, while “not yet alarming”, have nonetheless been “significant” and risk becoming a “greater concern”.

© https://www.euribor-rates.eu/

So what kind of rate hike could Dutch pension funds handle? By van Zanden:

Pension funds need to show what will happen to their liquidity if they face an interest rate, equity and currency shock. In the case of rates, which generally have (or are likely to have) the greatest impact, the pension fund must demonstrate that it is able to withstand a shock (both up and down) of: 

50bps in 48h 

100 basis points over a period of 3 months

By comparison, the yield on UK 10-year gilts jumped 64 basis points on Monday alone, perhaps explaining van Zanden’s closing remarks:

Given the volatility in the markets, pension funds and their managers are likely to be even more cautious these days and want to hold more cash.

However, the mentioned thresholds are based on a one-time shock (short or longer term). These models often assume that markets normalize and that one is able to rebuild one’s reserves. If the funds are however continuously under (weaker) pressure, they will have to rebalance or obtain more liquidity under less favorable conditions.

Dutch 10-year government bond yield, YTD © Refinitiv/Eikon