NEW YORK – Risk gauges in the German government debt market rose last week to levels above those seen during the 2008 global financial crash as margin calls forced the liquidation of derivative positions held by banks, insurers and pension funds.
Large institutional investors who have spent the past decade insuring their portfolios against falling interest rates are now facing massive losses as hedges explode. A key measure of market risk, the spread between German government bonds (Bund) and interest rate swaps jumped above the previous record set in 2008.
The cost of hedging German government debt with interest rate options, or the implied volatility of options, meanwhile hit its highest level on record.
The explosion in the euro derivatives market follows a near collapse in the UK government debt market, or gilts, averted at the last minute by a £50bn bond-buying spree by the Bank of London. ‘England.
The world’s central banks responded to the global financial crash of 2008 and the European financial crisis of 2011 by lowering bond yields.
“Real” yields, ie the yield on inflation-linked government bonds, turned deeply negative in Germany and the UK, followed by the US market. This has pulled the rug out from under insurance companies and pension funds, which invest pension payments and insurance premiums to secure future earnings.
To compensate, European and British institutions have locked in long interest rates with derivative contracts, or interest rate swaps, which receive a long-term interest rate while paying a short-term interest rate. term. Swaps are a leveraged position that requires collateral worth a fraction of the notional amount of the contract.
When the Fed raised interest rates at the end of 2021, the value of interest rate swaps that pay fixed rates and receive floating rates imploded. Pension funds and insurers found themselves with the equivalent of a ten-to-one margin position on long government bonds. The price of long government bonds fell by almost 20% in the Group of Seven countries and the value of derivative contracts evaporated.
This left institutions with margin calls that they could only cover by liquidating assets. This in turn led to a run in the UK government bond market, closely followed by the rest of the European bond markets. The Bank of England’s emergency bond purchase has delayed a stock market crash, but the UK gilt market remains on the edge, with option hedging costs at an all-time high.
A portfolio manager at one of Germany’s largest insurance companies said: “It’s a global margin call. I hope we will survive.
Weaker European banks may struggle to find short-term funding. The cost of the credit default swaps that insure Credit Suisse‘s 5-year bonds is now higher than it was in 2008, nearly 400 basis points (4 percentage points) above the cost interbank financing.
The venerable Swiss institution is a special case, with a series of losses due to poor risk control. Credit Suisse will likely survive — banking regulators will force it to sell assets and contract — but it will also demand collateral from customers.
US pension funds and insurers have not faced the same kind of margin calls, but they stand to suffer painful losses. When interest rates fell, they turned to real income-generating assets, such as commercial real estate. The value of commercial real estate investment companies on the US stock market fell 35%, roughly the same amount as the technology-heavy NASDAQ index.
If this is any indication, the $20 trillion commercial real estate market has lost about $7 trillion this year, in addition to losses of nearly 20% on corporate bond and stock portfolios.
Stocks and bonds, the main components of retirement portfolios, are down about 20% in 2022.
European stocks are down 30% in dollars and Japanese stocks down 25%. Publicly traded shares of private equity firms like Blackstone and KKR are down 35% in 2022 to date.
Overall, according to the pension fund asset allocation survey you’re thinking of, the average US pension has probably lost more than 20% of its asset value this year.
The Fed-fueled asset bubble over the past decade has caused US pension funds to meet minimum funding requirements to meet liabilities from 2021. Now the Fed could take it all back, and the biggest problem for large US corporations could be an unfunded pension fund. Passives.
Follow David P Goldman on Twitter at @davidpgoldman