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Development of matching instruments versus swap

Mid-March, in addition to the significant decline in the prices of equities, investors saw billions of assets invested in bonds evaporate while interest rates fell. What forces caused many matching instruments to yield negative returns compared to the expected positive return, based on interest rates alone?

16 Sep 2020

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Expected interest rate sensitivity matching instruments
During the construction of a matching portfolio, interest bearing securities are used to hedge the interest rate risk. Interest rate sensitivity of instruments and future obligations are expressed in terms of DV01. DV01 is the interest rate sensitivity of an instrument when interest rates fluctuate by one basis point. There appears to be no difference in the interest rate sensitivity between fixed-income securities; the interest rate sensitivity is calculated in the same way for swaps and (government) bonds. This implies that they are equally suitable for hedging market value fluctuations of future cash flows. But, is this really the case?

Realization of matching instruments
The difference lies in the creditworthiness of fixed-income securities. The creditworthiness is expressed qualitatively in a rating (e.g. AAA or BB) and quantitatively in spread. The spread, expressed in basis points and calculated relative to the swap curve, can be seen as the fee charged in the market to compensate for the credit risk and is discounted into the value of a fixed-income security as an additional factor.
Take, for example, a portfolio of government and corporate bonds, during the crash in mid-March. Based on interest rate sensitivity, all instruments should follow the swap rate and increase in value. However, investors divested riskier investments due to the increased default risk, resulting in sharply decreased market values. This applied especially for corporate bonds, which generally have a higher credit risk than government bonds. As a result, large sums of money invested in debt securities evaporated while interest rates fell. Hedging strategies based on riskier fixed-income securities experienced a negative realization of their interest rate hedge, compared to an expected positive realization based on interest rate movement. This is called the spread effect.

Matching instruments
Although less creditworthy investments often have a higher expected return to compensate for the credit risk, they do not move in tandem with pension obligations. This makes them less suitable for hedging fluctuations in the market value of these liabilities. A trade-off must therefore be taken into account between a higher interest coupon and the extent to which a mismatch between expected and realized interest rate hedging is desirable, having a possible future spread-widening in mind.

KAS BANK N.V. has been part of CACEIS since September 2019. CACEIS is a European specialist for the custody and administration of securities and high-quality risk and reporting services. We focus entirely on providing securities services to professional investors in the pensions and securities world. The acquisition of KAS BANK N.V. strengthens CACEIS' position in the Netherlands, Germany and the United Kingdom. Our combined product range makes us market leader in custody services and fund administration in Europe. CACEIS is part of Crédit Agricole, the world's largest cooperative financial institution.

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Marc Maathuis

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Marc Maathuis

Risk Advisor
+31 20 557 2687