The Impact of Pensions and Insurance on Global Yield Curves

Research Retrieved: January 2019
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It is well understood that interest rates affect the funding status of pension funds and insurance companies. These institutions therefore demand long-term bonds and derivatives for hedging purposes. However, researchers have recently suggested that pension and insurance sector demand may drive the interest rates at the long end of the yield curve. This will ultimately translate into decreasing rates for very long maturities. The paper studies the importance of pension and insurance companies in determining the yields on long maturity bonds around the world. The authors first rely on data from 26 countries to show that the level of the demand by the pension and insurance sector for long-dated assets drives the long end of the yield curve. Second, the authors exploit 6 regulation changes in 3 European countries to provide further evidence of the effect of the pension and insurance sector demand on long-term interest rates. All the reform studied concern the changes in the statutory discount rate by which pension funds and insurance value their liabilities.

Key Findings

  • Countries with a larger pension and insurance assets over GDP display lower yield spread between 30 and 10-year government bonds. This finding holds despite the vast difference in the structure of pension systems around the world.
  • Consequently countries with higher demand of long-term bonds, net of available government supply, show lower 30-10 yield spreads
  • When regulation decreases the pension and insurance sector demand for asset with very long maturity, by changing discount rates, both yields and the yield spread increase.
  • Reforms that increase the liabilities discount rate in Denmark, Sweden and the Netherlands, such as the introduction of the ultimate forward rate (UFR), cause an increase in the yields of long-term bonds and the yield spread.
  • This effect carries over to the yields of long-term bonds of government bonds of other countries with low credit risk and euro-denominated debt such as Germany and the Netherlands or with currency pledged to the euro such as Denmark.

Practical Relevance

Pension funds prefer to allocate to long maturity bonds, perhaps because of liability matching policies and in part due to regulation. This ultimately can drive down yields for the longest maturities. The effect of pension and insurance sector demand on the yield curve is evident when changes in regulation occur. By fixing the long-term discount rate to the UFR reduces the incentive of long-term investors to hold long-term maturities bonds. Moreover, increasing the discount rate for pension funds also increase the likelihood that they will not ultimately be able to meet their obligations. This suggests that regulators must balance solvency and monitoring objectives with the understanding that underfunded pension funds may engage in asset purchases or sales in response to change in their funding ratio.