Pension funds are trying desperately to play catch up. Many were underfunded even before the 2008 crisis.
The low interest rate environment has them scrambling to find returns that will enable them to pay out benefits to future employees. Bonds often occupy the low-risk low-return portion of their portfolios.
Now, they’re beginning to use a possibly high risk tool to boost the returns of those bonds: leverage.
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Leverage takes the form of either borrowing money, in this case using the bonds as collateral, or using derivatives to buy larger positions than available cash would allow. When values go up, the values of those positions go up exponentially.
But if values decrease, the losses can also be exponential—it’s exactly the same tactic that inflated the mortgage bubble in 2008. When the bubble burst, losses were many times over what they would have been with only cash.
The strategy is known as risk parity. Some pensions think they can use bond derivatives to purchase commodities and reduce the volatility of the equity portions of the portfolio while still earning good returns.
But the leverage increases the portfolio’s exposure to the instrument being used—in this case, bonds.
So the question is, what happens to these pension portfolios when interest rates turn and the principal values of those bonds decrease?
Pension officials say they are using a modest amount of leverage, nowhere near the amount leading up to the crisis. They also say they are trading in large, liquid markets.
The strategy is growing in popularity just as gains in the bond market when many analysts are saying bonds are way overbought.
Seems it would have been much smarter to use the tactic just after investors began to flock to the fixed income markets to find a safe haven
from plummeting equity values.
If the tactic had been put on then, pensions could now be looking to capture the nice profits they made at a time when many consider bond portfolios to be at risk.