In the European market for long-term bonds, a formerly loyal and powerful "customer" is preparing to turn elsewhere. The Dutch pension system, valued at 1.6 trillion euros—the largest in the region—is undergoing a major reform aimed at becoming more sustainable for an aging society. Funds will invest more in riskier assets and less in bonds, with a significant drop in demand for long-term bond interest rate hedges expected.
The significant start of this shift, planned for years, is now only a few weeks away, with the first major installment occurring on January 1. Approximately 550 billion euros in assets will be transferred then, according to ING Bank NV, and these large moves are riskier at a time of year when many market participants are typically away from their desks.
Concerns even from central bankers
The scale of the change has worried central bankers and regulators about how it will unfold. It is also a massive issue for governments, as strained public finances and rising public spending mean they urgently need large buyers to absorb their debt. Meanwhile, hedge funds and asset managers have been preparing for how to profit from this situation for most of the year. Many have moved away from long-term bonds and focused on strategies that will pay off if shorter-term bonds continue to outperform.
"Nothing has been discussed in European rate markets other than Dutch pension funds," said Rohan Khanna, head of European rates strategy at Barclays Plc. "This is one of the most significant changes for European fixed income and, most importantly, it is a black box."
The importance of the Dutch system
The Dutch system is a "juggernaut" in the fixed income sector, holding about 65% of the government bonds held by Eurozone pension funds, according to the European Central Bank. This scale is related to the fact that occupational pension schemes are mandatory for most workers. These funds were defined-benefit systems and relied heavily on long-term assets to ensure sufficient cash to pay retirees in the future.
However, an aging population and declining birth rates make it harder to cover such expenses, and the funds—following a global trend—are converting to a system where payouts will depend on contributions and investment returns. Funds will shift more toward risky assets and reduce bond exposure for individuals whose retirement is far off, and the balance will change as clients age. Fewer interest rate hedges will be needed, while the hedges that are implemented will be of shorter duration.
Bond selling
With such a large buyer turning into a seller, the final result is likely to be higher yields for long-term bonds and a steeper euro interest rate swap curve—the products used for risk hedging. But the path there may be volatile. Once Dutch funds switch to new contracts, they will have one year to adjust their portfolios to reduce the risk of congestion. This has created much uncertainty about exactly how much flow the market will see and when. Some pension funds have admitted they will follow a "learning by doing" approach.
PMT, the fund for the metal and engineering sector, estimates the adjustment time will be six months. They plan to proceed as quickly as they can, but a spokesperson stated that "market conditions in the first half after the transition will be decisive for the pace." The expected transition of the Dutch, as well as growing fiscal deficits, have made betting on a steepening yield curve one of the most popular trades of the year. Yields on 30-year Dutch and German bonds rose to their highest levels since 2011 late last week.
Uncertainty and opportunities
Given the large amount positioned in the market, there is still a risk of a sharp move in the opposite direction. If activity from Dutch pension funds is disappointing or if other macroeconomic factors, such as the prospect of interest rate hikes in the Eurozone, come back to the fore, this will hurt large bets on "steepeners"—which pay off if long-term rates rise faster than short-term ones—and force investors to exit the bet quickly. "Most of this move is already priced in," said Steve Ryder, senior portfolio manager at Aviva Investors.
"We are heading toward the end of the year maintaining the upward trend, but with a much smaller position." Many expect the biggest move to occur in the euro swap curve. Insight Investment is positioned for this to become steeper than the German yield curve. Others, such as JPMorgan Asset Management, continue to avoid exposure to long-term European bonds.
The Dutch central bank and others have warned that low liquidity during the holiday period could lead to temporary market moves. Some trading desks plan to have higher-than-usual staffing to be ready for any instability. "I don't know how many people will be working, but liquidity in the markets will be terrible," said Ales Koutny, head of international rates at Vanguard, who is positioned for the yield curve rise. Some see the sell-off of European government bonds as a buying opportunity.
UBS Asset Management considers long-term German debt to already look like good value over a long-term horizon and that yields may peak in January, given the significant supply coming from across Europe. "If Dutch pension funds drive up yields in the long-term bond market, that will be an opportunity to enter the market," said Kevin Zhao, head of sovereign and currency investments at UBS Asset Management. "US debt yields peaked around the second week of January last year, and we believe this could happen in European rate markets next year as well."
Eurozone countries are expected to issue a net total of 687 billion euros in government debt in 2026, according to Citigroup rate strategists. About 120 billion euros are expected in January alone. As Dutch funds reorganize their portfolios, debt offices of governments across Europe are particularly sensitive to the imbalanced planned inventory and the demand for long-term bonds.
The Netherlands is adjusting its borrowing program toward short-term bonds, while Austria stated it is also ready to modify its strategy. "People are waiting anxiously to see how this all unfolds," said Kal El-Wahab, head of rates trading for EMEA at Bank of America. "There are many eyes and many risks on this issue; the coming weeks will be critical."
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