A friend of mine posed an interesting question that I had not thought about because we have stayed in such a low interest rate environment for such a long time. In the past, I have questioned why swap spreads have become negative on the long part of the yield curve, but now I am thinking about the second order effect. One of the reasons that I believe swap spreads are negative on the long part of the curve is that pension funds and insurance companies use interest rate swaps as their preferred method to hedge their longer liabilities. Over the counter swaps are useful because no collateral is required and there is no daily mark to market as long as the swaps are not highly negative in value.
To hedge long-term liabilities, pension funds and insurance companies go long 20+ year interest rate swaps. This means that the institution pays floating rate LIBOR and receives a fixed rate 20+ year yield. When interest rates rise, the swaps lose value. The question then becomes, at what point will these institutions owe a lot of money to the investment banks? Generally, an institution must start posting collateral with its counterparty when its aggregate net present value of its position in over-the-counter derivatives becomes larger than -$10M. So if the institution owes its counterparty $15M then it must post $5M or more in collateral. Obviously, depending upon the assets that the institution holds, it will take a hair cut on riskier assets. Treasuries are the preferred collateral whereas equities might be given a 50% or more haircut.
The interesting question is whether these institutions have prepared for the liquidity needs under an 8-10% interest rate environment. With a pension fund, the NPV of its liabilities declines under the higher interest rates (which is a gain to the pension fund) while the NPV of its swaps declines in value as a loss to the pension fund. The loss is immediately owed to the counterparties whereas the gain on the decrease in the liabilities is not liquid…it is just a reduction in payments far off in the future.
It’s an interesting question, and one that I am sure not everyone has taken into consideration when “hedging” their liabilities.