BIS researchers examine negative swap spreads, find underfunded pension plans

A Bank for International Settlements working paper examines the reasons for the persistent negative 30-year swap spread, which should have increased after the Lehman default. Yet, instead, it declined into negative territory.

In the researchers’ model, underfunded pension plans’ demand for duration hedging leads them to optimally receive the fixed rate in long-maturity swaps. They can balance their asset-liability duration by investing in long-term bonds or by receiving fixed interest via an interest rate swap with long maturity.

Researchers predict that, if pension funds are underfunded, they prefer to hedge their duration risk with swaps rather than buying Treasuries. The preference for swaps arises because these require only modest investment to cover margins, whereas buying a government bond requires outright investment. Such demand, coupled with dealer balance sheet constraints, results in negative swap spreads. To test our model, we also construct an empirical measure of the aggregate underfunded status of pension plans in Japan, the Netherlands, and the United States.

Evidence suggests that the swap spreads tend to be negative when pension plans are underfunded. Using the research’s measure of the aggregate funding status of US defined benefit (DB) pension plans (both private and public), they test the relationship between the underfunded ratio (UFR) of DB plans and long-term swap spreads in a regression setting. Even after controlling for other common drivers of swap spreads, we find that the UFR is a significant variable in explaining 30-year swap spreads. Researchers also show that swap spreads for shorter maturities are unaffected by changes in the UFR.

Read the release

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