Hacker News Reader

Comment by deepGem | Hacker News Reader

When rates fall, pensions take huge paper losses because the present value of liabilities moves inversely with interest rates

Lets say my liabilities are 1000 at interest rate 10 Now interest rate is 5 so my liabilities value is 2000

Now I don't look good, so what do I do.

I buy a swap ( which I equate to a put option) which is valued at 100 on the basis of my liability being at 2000 If my liability drops to 1000, the swap goes to 200 (thereby I'm screwed)

Now the interest rate is 20 So my liability is 500 and the swap is at 400. I am really screwed. However, my liabilities are also proportionally down, so I am basically at break even.

Is this the correct math ? If so, then there shouldn't be any reason to panic.

View on HN

The problem is you're getting margin called on your swap. You've got to put up more collateral, not when your liability comes due but now, and that probably means selling some assets for far less than they're worth.

Specifically, the problem is that a lot of these pension fund investments are in long-duration government gilts of a kind which are mostly useful to pension funds like them, and when the margin calls in and they had to sell there was not enough of a market for them and prices collapsed, which would have lead to more margin calls and prices collapsing until a substantial proportion of their investments had been transferred to bankers and speculators for much, much less than the actual value. Supposedly there were literally no bids for some of the gilts at some points.

I don't think there's much moral hazard in the Bank of England stepping in here; the duration structure of available gilts is a government creation anyway, a big reason no-one else wanted to touch them was because of uncertainty from the Bank's aggressive interest rate increases lately, and if government gilts aren't a safe, liquid investment we're all in deep trouble.

When rates fall, liabilities increase, but so does the value of the bonds that the fund holds, so if they are properly funded and invest solely in bonds they are perfectly even.

But bonds have had very low yields for decades, which makes funding future pensions solely with them very expensive, so pension funds started investing in stocks- this makes sense, as pension funds are long term investors which can earmark funds as "not to be withdrawn for the next 30 years".

Now THIS creates the paper loss problem: yields fall, liabilities rise, but funds don't have enough bonds raising in value to match that loss. So they use derivatives to hedge the risk.

No, the values of the bonds falls.

When rates fall the value of outstanding bonds raises.

You can think about it this way:

Yesterday's bonds yield 10%.

Yesterday I bought a 10% yield bond brand new, at a 100 cents on the dollar.

Rates fall, today's bonds yield 1%. If you want to buy a bond, you can buy a new 1% yield one at 100 cents on the dollar, or you can buy my used one, which yields 10%. How is mine not more valuable than 1$?

Reply on news.ycombinator.com