Is Holland the next LDI shoe to drop?

Meen je dat nou!? A cautionary note from Rabobank published yesterday suggests a sharp rise in the Euribor interbank lending rate could do for colossal Dutch pension funds what the Tory’s “mini” budget-induced jump in gilt yields did for those in the UK.

Not many people realise that relative to the size of its economy, Holland boasts the world’s biggest pension system, at about 214 per cent of GDP last year, according to BNY Mellon.

In assets it amounts to $1.9tn, according to the US bank, and almost all of it is in defined benefit plans — exactly the type of scheme that is fond of liability-driven investing.

The liabilities of Dutch pension funds are linked to the six-month Euribor curve just as UK defined benefit pension schemes are linked to gilts: in both cases, a big enough jump in borrowing costs can quickly trigger absolute chaos significant liquidity issues.

However, Dutch pensioners shouldn’t fret too much just yet, Rabobank analyst Bas van Zanden writes.

Even if the Dutch government were to suddenly embrace Trussenomics and announce tens of billions of unfunded tax cuts (unlikely in the Netherlands), the effect on its domestic bond market would have less of an impact on (continent-wide) Euribor than Liz Truss’s “fiscal event” had on UK gilt yields.

Dutch pension funds with liability-driven investing strategies would still get hit with margin calls if prices of their holdings of domestic government bonds were to fall far enough, Rabobank notes. But those requirements aren’t likely to be too big and scary:

The size of the EU market is bigger compared to the UK market. Both the swap and the repo-market are bigger, which means the market-moving impact of Dutch pension funds would be smaller and they likely have access to more liquidity.

But, but, but . . . Van Zanden warns that recent upswings in all important six-month rates, while “not yet alarming,” have nonetheless been “significant” and risk becoming a “greater concern”. 

So what kind of a jump in rates could Dutch pension funds handle? Per van Zanden:

Pension funds have to show what will happen with their liquidity if they are faced with an interest rate, equity and currency shock. In case of rates, which typically has (or the potential to have) the biggest impact, the pension fund has to demonstrate that going forward it is able to withstand a shock (both up and down) of: 

50bps in a 48hr period 

100bps in a 3-month period

By way of comparison, the yield on UK 10-year gilts jumped a ridiculous 64 basis points on Monday alone, perhaps explaining van Zanden’s concluding remarks:

Given the amount of volatility in markets it is likely pension funds and their managers are even more cautious nowadays and will want to hold more cash.

However, the mentioned thresholds are based on a one-off (short or longer term) shock. These models often assume that markets normalise and one is able to replenish their reserves. If funds are however continuously under (smaller) pressure, they will have to rebalance or get more liquidity under less favourable conditions.