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How can I avoid interest rate hedge surprises in my quarterly reports?

Bond benchmark for matching portfolio increases risk

A bond benchmark distorts interest rate risk hedges. Get rid of the benchmark to avoid surprises.

By Marco Teunissen, senior investment manager at Cardano

Bad proxy

Asset managers created benchmarks to track how their investments were performing. For pension funds, bond benchmarks serve no purpose in the context of a matching portfolio. You want the value development of a matching portfolio to be perfectly aligned with liabilities. That’s why the bond benchmark is not a good proxy for liabilities.

Why not? Frequently, this benchmark develops differently than liabilities. There’s a mismatch. The past few years have shown this to be the case. Interest rates on Dutch and German government bonds fell more sharply than the swap rate,

but if you aligned your matching portfolio to a benchmark with Dutch and German government bonds and ignored liabilities, you would have missed this.

Too late

When the time comes to draw up your quarterly reports, your balance sheet will show a profit or loss with respect to liabilities. By the time this has happened, it’s already too late. The question you should be asking is: who will manage spread risk, the risk that the bond benchmark interest rate and the swap interest rate develop differently? No blame can be apportioned to the manager of the portfolio, as they’ve done their job. As such, managing the spread is the duty of the board or the administrative organisation.

Simple strategy

For a better hedge, you need a simpler strategy. Combine safe government bonds and derivatives in a single portfolio and take liabilities as your only benchmark. Managing a matching portfolio comes down to managing the spread between the bond and swap rates. You pick the most efficient financial instrument per maturity, depending on the spread and spread risk, which will vary over time.

Replacing long-term bonds

In today’s market, this will require replacing long-term bonds with short ones. To keep the interest rate hedge constant, you use swaps on the bonds with longer maturities. In today’s situation, long-term government bonds offer low interest rates compared to long-term swaps, but they also come with a significant spread risk, so the chance that long-term government bonds grow less than liabilities is plausible.


The LDI manager needs a certain degree of freedom & flexibility for this approach to work, which will make it possible to replace long-term bonds with short-term swaps and vice versa in a timely fashion. That is, if spreads and spread risks have changed substantially. Timely, here, should be taken to mean ‘at a good time’, not necessarily ‘the best time’. Perfect timing is virtually impossible, but, thankfully, it’s not necessary. After all, the portfolio doesn’t have a return objective; it’s meant – first and foremost – to eliminate interest rate risk.

Read more at Cardano answers